Wall St. WTF

Shoddy reporting by Bloomberg Blames the Fed and Lets Congress off the Hook

2011-12-06T15:39:00.001-08:00

I would like to examine in some detaila recent report by Bloomberg about the actions of the Federal ReserveBank during the depths of the 2008 financial crisis. Bloomberg,through a FOIA request, gained access to the records of the variousfacilities that the Federal Reserve created to inject liquidity intothe banking system during the darkest hour of the financial crisis.At the time, the Fed disclosed the program in aggregate but did notidentify specifically which firms were lent how much for how long.They argued that this was to avoid a stigma among the banks who mightotherwise delay seeking liquidity for too long and thereby turn aliquidity problem into a solvency problem. For filing the request Ithink that Bloomberg should be congratulated because it sheds quite abit of light on just how deep the freeze in short term lendingmarkets became not merely among the banks but among corporates aswell.

That said, the recent Bloomberg pieceon the program which has stirred much controversy is a rather shoddypiece of sensationalist journalism designed to inflame rather than toinform. The over-arching narrative of the article, which came out onNovember 27^th is that the Federal reserve liquidityfacilities totaled $7.7 trillion dwarfing the Congressionallyapproved $700 billion TARP. The articleasserts that, unlike the TARP, these funds were lent “with nostrings attached” and that the fact that their recipients were notindividually disclosed obscured just how serious the financial crisiswas and therefore have hobbled the efforts of the legislature toreform the financial regulatory system as evidenced by the defeat ofa bill to break up the top six banks or to reinstate Glass-Steagall.

The first things which draws the eye isthe $7.7 trillion figure. They don't actually give too much detail asto what this comprises other than to say its what you get if you “addup guarantees and lending limits.” This number is highly suspiciousbecause the total balance sheet of the Fed today, after two rounds ofquantitative easing, stands at $2.8 trillion. How is it possible forthe Fed to have lent a sum almost three times the size of its currentbalance sheet almost a trillion dollars larger than it was at thetime? Well, it's not.What they are doing is counting all the loansmade regardless of term which VASTLY overstates the extent of theamount of money at risk.

Here's how it works: let's say I lendyou a million dollars over night and you pay me back the next day.Let's say we do this every day for 260 business days over the courseof a year. Have I lent you $260 million over the course of a year?Yes. Was it ever possible for me to lose $260 million? No. the most Icould lose was $1 million on any given day since if you don't pay meback you don't exist the next day for me to lend you another million.So to count all the loans over the entire time period in a singlestatement is to greatly inflate the sums involved. Which, of course,is precisely the objective of the Bloomberg article because it getsattention and with it clicks and reposts which you can see if yougoogle “Federal Reserve $7.7 Trillion.”

That's the most egregious thing in thearticle and I almost forgive them because the click-based economicsof internet journalism almost demand some kind of preposterous claimto encourage and diffusion of the article through social media. Theydo stick with that convention throughout the article which isunfortunate but they often refer to the days of maximum borrowingwhich give a better insight into the actual scale involved. What theydon't do is provide any context as to what the relative importance ofthe Fed loans was to the overall capital structure of the firms nordo they compare the relative importance of the TARP and the Fedprograms in order to support their claim that had the Congress knownabout the Fed program that much of the regulatory effort would bedifferent. Luckily this perspective is actually pretty easy to comeby, all that is required is a quick look at one of the largerrecipients of both the Fed programs and the TARP. So let's have alook at JP Morgan. According to the documents that Bloomberg hasacquired JP Morgan's borrowing peaked on February 28^th2009 at $45 billion. $45 billion? Whoa, sounds like a lot. They evenpoint out in that this was larger than the cash holdings of JPMorgan. OK, let's have a closer look at the balance sheet from thatera via the JPM 10-Q, here it is for your reading pleasure:

OK, sure enough the cash holdings ofJPM were $26 billion, less than the amount of the Fed loans. The Fedloans would be in the section under “Liabilities” entitled “OtherBorrowings” which totals $112 billion. Wait a minute, it seems fromthe Bloomberg article that JPM was entirely dependent on the Fed forits borrowings, in fact the Fed was less than half of the short termloans that JPM was funding with at the time. Actually the more youlook, the less important the Fed loans are. The balance sheet as awhole is $2,079 billion, so the Fed is meeting around 2% of thefunding needs of JPM not a huge number but let's think about whatwould have happened had the Fed withdrawn its support. Well, giventhat the cash position of JPM was $26 billion, they could have selffunded that bit and then come up with an additional $19 billion whichthey could have done by converting $19 billion of their $90 billionin deposits at other banks to cash. So it would not have been fatalto JPM after all.

So if it wouldn't have been fatal tothe bank then why do it at all? Well the answer to that is also seenon the balance sheet, as is the need for secrecy. Notice whathappened from December 2008 to March of 2009, the balance sheetshrank by about $100 billion in total, as you can see total depositsshrank by the same amount. In essence there was a general level offear in the economy that was leading people to pull their money outof the banks. JPM could have done without the Fed's support but to doso it would have had to withdraw $10 billion or so from other banks,and those banks in turn would have had to withdraw their money fromother banks as well. This is what the Fed was trying to prevent, ageneralized withdrawal of liquidity from the banking system whichwould have halted lending altogether and withdrawn a lot of liquidityfrom the general economy as banks shrank their balance sheets.

The Fed was able to stabilize thebanking system with relatively small amounts of capital relative tothe balance sheets precisely because of the policy of secrecy of theprogram. It was entirely possible that if they had disclosed at thetime that this or that bank was borrowing from the Feds liquidityfacilities that already spooked depositors would accelerate theirwithdrawals and thus force the banks to withdraw more money from oneanother or else further shrink their balance sheets. It would havebeen possible for the Fed to grow the program in that event but thefact that no one knew which bank was borrowing how much when meantthat it wasn't possible to panic about any individual bank thoughthere remained a fair amount of fear in the system as a whole.

So the liquidity program of the Fed wasvery helpful in supporting the banking system as a whole but it wasnot vital to any individual bank. It might have become a more acuteissue if the Fed at the time had not maintained the veil of secrecyaround it. The relatively mild nature of the program despite itssecrecy is one reason why I do not think that more general knowledgeof it would have affected Congressional regulatory actions after thecrisis. The other is that while the Federal Reserve liquidityfacilities were helpful to the banking system as a whole, the trulydecisive government program was the Congressionally funded andoverseen TARP program without which it is far more likely that thebanking system would have collapsed entirely.

When thinking about the relativeimportance of the Fed's facilities and the TARP is the nature of theproblems they were designed to solve. The Fed was primarily concernedwith liquidity, the TARP with solvency and solvency was BY FAR themore serious problem. Liquidity is a question of at what cost mustthe firm get the funds it needs to operate day to day. Solvency is aquestion of whether the assets on the balance sheet are worth more orless than the sum of the liabilities plus the equity and thus whetherthe firm in fact exists. At the time Congress was aware of the whatif not the who of the efforts on the liquidity front but it had afront row seat for the efforts on the solvency front.

When discussing this it is important toremember what happened during the Lehman bankruptcy. The Friday nightbefore the collapse Tim Geithner called the heads of the big New Yorkbanks and investment firms to a meeting and ordered them to come upwith a private sector rescue for Lehman Brothers. This was by nomeans even remotely possible, which Geithner should have known,because at the time the markets for securitized mortgages, the mostproblematic items on the Lehman balance sheet, had ceased to functionwhatsoever and the securities which comprised it were so complex thatit was not possible even to model them with any degree of certainty.Therefore any would be rescuer would have to take a leap into theabyss and given the fact that the Lehman balance sheet was $600billion, it was well beyond the capacity of the other banks in theroom to saddle their own shareholders with the potential losses.

Those fears proved extremely wellfounded. After the collapse of Lehman there was an auction todetermine the settlement price for CDS on Lehman Brothers whichresulted in valuing the recovery rate, that is what unsecuredcreditors of Lehman could expect, at 9 cents on the dollar meaningthe size of the balance sheet hole was gargantuan (and incidentallyif the banks had obeyed Geithner he would have destroyed the entiresystem.) The knowledge of how deep that hole was sent waves of panicthrough the markets are called into question the balance sheets ofevery bank which also engaged in mortgage securitization, which wasall of them. This is important because if it were the case that theassets of the remaining banks were worth less than the liabilitiesand the equity the banks would be insolvent. Fear of this led peopleto being withdrawing their funds from banks exacerbating theliquidity crisis. It was entirely possible for that liquidity crisisto develop into a solvency crisis by its own momentum which is whyCongress enacted the TARP.

The TARP injected $250 billion onto thebalance sheets of the banking system at the preferred stock levelthereby adding an essential additional layer to the capital structureof the firm. Equity is the key element in this because the firm issolvent as long as the uncertainty around the balance sheet is lessthan the equity because it means all the unsecured lenders willrecover all their funds in the event of a liquidation. This is whythe TARP was structured in the way that it was and why it was crucialfor the survival of the system as a whole, far more so than the Fedprograms. At the time of the peak borrowing from the Fed the commonstock of JPM was worth about $65 billion and the firm had $35 billionof preferred stock including $25 billion of TARP funds. So while theFed was providing about 2.5% of the borrowings of JPM the taxpayerwas providing 25% of the equity. So for Bloomberg to claim that thedecisive aspect of the bailouts was the Fed liquidity facility is todo violence to the facts.

The Fed programs have largely beenunwound and resulted in no losses to the Fed. The TARP still hasbillions outstanding and will result in losses to the taxpayers ofabout $30 billion. So of the two programs, by far the more crucialand the more painful for the taxpayers was the TARP rather than theFeds liquidity programs. Thus it is quite disingenuous for Bloombergto claim that had there been more knowledge of the specific borrowersfrom the Fed that there would have been more effective regulation ofthe banking system in the Dodd-Frank Act. It is quite true that thereare serious flaws in the Dodd-Frank Act and there has been a veryeffective campaign against implementation of some of the more usefulfeatures but to claim that this is because of a lack of knowledge ofthe Fed program is to provide a smoke screen for the real issuesbehind the failures of Dodd-Frank and to let Congress off the hook.

My Suggestion for Occupy Wall Street Demands

2011-10-05T15:10:00.000-07:00

So, though the market action has beenhighly interesting lately and the drama in the Eurozone is extremelycompelling I would like to take some time today to lend a hand to themarginally important though highly amusing Occupy Wall Streetmovement. The movement is emotive if incoherent not unlike the TeaParty. There has been some concern lately that while they are unhappyabout a great many things they have little in the way of concretesolutions or even demands. A website affiliated with them did publisha draft of potential demands but it obviously cannot be takenseriously because, like the movement itself, it has virtually nounderstanding of how the world actually works and therefore cannotaddress itself to the root causes of the problems which vex them so.

So I have decided to publish what Iconsider to be a more reasonable list of demands that I think wouldactually go a long way toward resolving many of the issues which facethem. My views on the solutions to the economic ills facing the country are so counter to the thoughts of the OccupyWallStreet crowd that they require a separate post. However, fundamentally I agree with the protestors that the influence of well financed special interests has totally undermined the Democratic process and largely captured the state.

First I will list some assumptions:

Corporations and people respond to incentives, the key element in controlling behavior is not to simply enact rules but to enact rules and laws which consider second order effects, that is the ways in which individuals and groups will respond to them. The key is to focus on final outcomes, not initial rules.
Money in politics is here to stay. If you are going to tax and regulate business, business is going to seek to influence those taxes and regulations. If you make it illegal to donate to campaigns then you'll move to a revolving door regime such as we have with regulators and administration officials or corporations will find some other means to influence policy. The rewards to it are simply too great. The key therefore is not to eliminate money from the political system but to alter the political system in such a way as to minimize the influence that money can buy.

So with that in mind, here are my suggestions:

Quadruple the number of members of House of Representatives.

The average member of the house current represents about 650,000 people. This is such a large number that the only way for Congressmen to communicate with the voters is through mass media. Mass media is expensive. If you lowered the number of people that Congressmen had to win over in an election to a more manageable number then you would diminish the necessity of mass media buying and you would therefore also minimize the influence of money in elections.

As a second order effect, instead ofhaving to pay off 435 Congressmen, large well financed specialinterests would have to pay off 1740. You would be raising the totalcost of influencing national policy but simultaneously lowering thecosts for any individual citizen to actually run for office. Thiswould have a substantially dilutive effect on the role of money inelections and would make Congressmen as in touch with theirconstituents as the mayor of a medium sized city.

Double the number of Senators

Same reasoning as the above.
Change the term of a house member to five years and a Senator to fifteen.

When the Constitution was originally written life expectancy in the US was about 40 years of age. Therefore a two year congressional term would constitute about 5% of the life span of the average person living in the country at the time. It was therefore a very serious time commitment and few people thought they would run more than a few times. Now that people live much much longer, most politicians plan on running for election several times. This is extremely expensive and makes fundraising a virtually constant demand on the time and attention of all public servants. The moment they are elected they have to be thinking about raising money for the next election. Why not take the pressure off, by making the term of office a similar life commitment to what it was in when the Constitution was first framed. Think about it, for several years, while there was no imminent election, it would be extremely difficult to influence the political system with money.
Implement non-partisan redistricting

This is absolutely essential. Todaymany Congressional districts are drawn up by partisan committeeswhich basically divide up the districts so that many of them are“safe” for one party or the other. Basically the parties largelydecide between them what their proportion of seats in Congress willbe. This has some very pernicious effects on governance. The mostimportant is that in “safe” districts the candidate really onlyhas to win the primary. Imagine a Congressional district with 650,000residents. Of these lets say 300,000 are registered voters. Of these150,000 will vote in the general election. Lets say that 85,000 ofthem are Democrats, and 65,000 of them are Republicans because thiswas designated a “safe” Democratic seat through partisanredistricting. Let's say that 20,000 of the most hard-core Democratsare going to vote in the primary to choose which Democrat actuallygets to run against the Republican who is almost certain to lose.First of all, the Rep has to only appeal to the most committed ofthat 20,000 in order to “represent” them and the other 630,000.Keep in mind, the people who vote in primaries tend to be VERYcommitted to their ideology which is why they pay attention to theprimary.

This kind of thing has a HUGE influenceon policy. Imagine you are a Tea Party Republican. You may think itsreasonable to include some tax increases in some kind of compromise.Of the 650,000 people in your district about 400,000 probably agreewith you. But, only 20,000 voters actually count because if you don'twin the primary you're out of the game before it starts. Let meassure you than on the Republican side those 20,000 guys don't wantto hear ANYTHING about raising taxes. So you're sure as hell notgoing to raise them.

Non-partisan redistricting is notperfect but it would go a long way toward breaking the strangleholdof the extremes on the right and the left over the political processand would return power to the more pragmatic and centrist elements ofthe political system.

So, that's my suggestion for a platform for the Occupy Wall Street crowd. You can't get the money out of politics but you can dilute its effect and refocus our elected representatives on serving the needs of the entire public rather than their special interests and ideological masters.

"The Twist:" Ben Bernanke channels his inner Vincent Vega

2011-09-21T15:50:00.000-07:00

I ain't saying it's right. But you're saying a the twist don't mean nothing, and I'm saying it does. Now look, I'm giving 400 billion bonds 400 billion duration shifts, and they all mean something. We act like they don't, but they do, and that's what's so fucking cool about them. There's a sensuous thing going on where you don't talk about it, but you know it, the Christine Lagarde knows it, fucking BofA shareholders know it, and Rick Perry should have fucking better known better. I mean, that's the fucking term structure, man. I can't be expected to have a sense of humor about that shit. You know what I'm saying? -Ben Bernanke in the todays Fed announcement.

Quite an action packed day today was.Today we got a large stock market move lower, down about 3%. This wasdriven by three news items.

First of all this morning existing homesales were released and the numbers were better than economistsexpected: 5.03 million vs. an expectation of 4.75 million. Most ofthe data out of the housing market has been pretty abysmal lately sothe markets took this with a grain of salt.

The second most important thing tohappen today was that Wells Fargo and Bank of America both had theirratings cut by Moodys to below AA. Though something along these lineswas expected it was still a big deal. The reason that its a big dealis that BofA and Wells Fargo are two of the four largest banks in thecountry. With the other large banks they have been struggling torecover from the near death experience that the financial systemunderwent in 2008. Yes they have paid back their TARP funds and havemore or less returned to profitability but there remains a hugeoverhang of sketchy real estate loans on their balance sheets. Therehas been a lot of speculation as to what these balance sheets areworth and generally the markets have their doubts which is why thefinancial sector has taken a beating all summer.

There are only two ways for the balancesheet problem to be fixed, one is for the assets in question (USresidential real estate) to recover significantly enough to removethe cloud of doubt as to what the true value of the balance sheetsare. Today's ray of sunshine notwithstanding the markets are not toooptimistic about this scenario. The other is to earn their way out,that is, if they earn enough money so that they can fill whateverbalance sheet hole there is with their profits then they'll be fine.The problem with the downgrade is that it will seriously impair theirability to make money.

Remember all a bank does is borrowmoney from savers and lend it to borrowers. What money they don'tborrow from depositors they borrow from other institutions at what isusually called LIBOR (The London Interbank Offered Rate. Believe itor not this was invented by the Soviet Union when they refused tohold their Marshall Plan Aid in US banks and so deposited it inLondon and the London banks had to figure out a generic interest rateto pay the Russians. Thus the offshore interest rate for US dollarswas born and has been called LIBOR ever since.) This is the rate atwhich banks generally lend to each other and the credit rating forLIBOR is generally assumed the credit rating is AA. Now BofA can'tborrow at LIBOR any more, it has to pay more. So therefore in theinterbank lending market BofA's costs of funds are higher. Interestcosts are the most important factor in bank profitability so losingtheir AA rating instantly means that they'll be less profitable andtherefore it will take them longer to close the balance sheet hole.

Interestingly one of the reasons thatMoodys lowered the rating was that they felt that the US governmentis less likely to bail out a troubled financial institution than itwas in 2008 because there is less risk of contagion. Since thesebanks were, formerly, considered too big to fail they'recorrespondingly riskier. This is interesting considering the highadventure going on in the European banking system right now. If thereis a Eurozone sovereign default then there will almost instantly be aMAJOR European banking crisis. This crisis will spread far and wideat high speed. I actually think that Moodys is correct thatgovernment assistance will not be forthcoming but not because thereis less systemic risk. There is a large and powerful faction withinthe Congress that was willing to let the US sovereign default. Do youthink they're willing to let Bank of America default? Sure are you'reborn.

Of course the most important news ofthe day was the Federal Reserve Statement. The Federal Reserveannounced, after a two day meeting, that they would move $400 billionof their Treasury portfolio from short dated securities to longerdated ones (an operation called “the twist”) and they wouldreinvest their maturing mortgage securities into new mortgagesecurities rather than Treasuries as they had been doing. They alsosaid that the economic outlook was increasingly gloomy and thatdownside risks were increasing.

So what does this all mean? First theeasy part, during the financial crisis when there was a massivecollapse in the mortgage market the Federal reserve stepped in andbegan buying mortgage backed securities. This was a controversialmove because the Fed usually government securities, it was adeparture from standard practice for the Fed to intervene in theprivate sector borrowing markets. Since the crisis, as the securitiesthat the Fed bought have matured the Fed has bought treasuries withthe proceeds, slowly getting out of the private sector mortgagemarkets and returning to its natural habitat of US governmentsecurities.

Their announcement today means that,going forward, they're going to be reinvesting back into mortgages.This will lower mortgage rates generally, or at least dampen anyincreases. The Fed is probably hoping that this gives a bump to thereal estate markets and thereby help the banks with problems theyhave with all the residential real estate on their books. The realestate markets are indeed in serious trouble so any little bit helpsbut I doubt that this will have a significant impact.

The main event of course was “TheTwist.” The repositioning of the government securities on the Fed'sbalance sheet from near term to long term. The nominal objective isto lower long term rates without affecting short term rates verymuch. They'll succeed in this because $400 billion isn't that much inthe very deep and very liquid short term US government securitiesmarkets, but its really big in the long term markets. Thus they canhave a lot of impact on long rates by buying but not too much impacton near term rates by selling. Keep in mind that because thetransactions will be offsetting this is not Quantitative Easing, soRick Perry can leave his shotgun on the gun-rack in his F-150.

What's behind this? Well, basically forthe past few years banks have had a free ride. The Fed has crushednear term rates to zero which, if you have a bank account of anykind, means that banks can borrow money from their depositors at nearzero interest rates. They could then buy ten year Treasuries at 3% orso and make that a risk free 3% per year and this is what they havebeen doing. Sure there has been some loan growth but why lend moneyinto the real economy if you can make this nice juicy 3% risk free?Well, sheriff Bernanke has come to town and is calling that gameover. What he's trying to do is force longer term interest rates solow that the banks are forced to move up the risk curve and startlending more money into the real economy.

Will it work? That is a really toughquestion. There are a lot of really good reasons to have your capitalclose to the vest right now if the banks hold back and stay wherethey are on the risk curve all the Fed has done is reduce theprofitability of the banking sector. You could look at today as a onetwo punch for the banking system, the downgrades lower increase theircosts and lower long term interest rates lower their revenues. On theother hand if they are forced out on the risk curve and at lowerrates that might be helpful for the real economy. This of courseassumes that the reason that loan demand has been so low is thatbusinesses think that long term rates, already the lowest in over adecade, are still too high. This is not likely. Far more likely isthat economic conditions are very uncertain and taxes on investmentare scheduled to almost double by 2014.

In any case the markets were not a fan.The S&P, which opened the day lower, dropped like a stone intothe close closing down 3% on the day. I think this is for threereasons. One, I think that though most market analysts correctlycalled the Fed action many market participants thought that Bernankemight do something more aggressive. There are serious problems inEurope and the US data is getting pretty bad. Bernanke has been veryinnovative and I think the markets thought he might have somethingelse up his sleeve perhaps even QE3. The fact that gold also droppedlike a stone and the dollar rallied seems to indicate that themarkets had baked a bit more loosening into the market cake. Alas, nojoy. The second reason I think is that the Fed remarks were verygrim. At the same time, the relatively limited action of the Fed thistime despite that grim data, and the relatively high number ofdissenters is a further indication that the tools the Fed has at itsdisposal are limited. Finally, I think that the speculative attack inEurope may have been on hold until the Fed made its announcement. Nowthat the Eurozone bond vigilantes know where Bernanke stands, they'refree to renew their assault on Fortress Europa. It should beinteresting.

I've come up with some ideas on how to create jobs. To pay for it I've decided to hire the guys who brought you the debt ceiling fiasco. Sound like a plan?

2011-09-12T12:23:00.000-07:00

There's a lot going on in the world butI want to write something on Obama's speech last week.

I was interested for two reasons.First, I have been studiously avoiding the clown car demolition derbythat is the GOP primary but I remain interested in the political contest,such as it is. Given that Obama's approval ratings are going over acliff and polls show he would lose against a generic Republican, ifnot any of the actual Republican candidates, this was an importantspeech for him. Second, I was very interested to see what sorts ofpolicy initiatives he would put forward. As you will see from my nextseries of posts I think that the trouble brewing in Europe isextremely dangerous to the global economy and anything the US can doto increase the rate of US growth would be very helpful at this stageof the game.

In the end, the speech was far moreinteresting from the political angle than from the economic angle. From a policy perspective the “American Jobs Act” contains a fewnew tweaks of the mechanics of unemployment insurance but otherwiseis more or less a $550 billion extension of the American Recovery andReinvestment Act (ARRA or “the stimulus.”) It contains someinfrastructure spending, extensions of unemployment benefits,transfers to states to pay public employees, an extension of thepayroll tax cut, and accelerated depreciation. I found this prettydisappointing. If $1.6 trillion of these initiatives failed to reviveemployment then why should another $550 billion do the job? To be sure the ARRA has its defenders though I am not one of them. I was doubtful that the President would bring something new to the table but I wanted to be surprised. In the end, my doubts were confirmed.

I should mention that in the 2008elections I supported Obama. I donated the legal maximum to hiscampaign both in the Democratic primary and in the general election.I had many reasons for doing this a short list would be that I wasdisgusted with the job the Republicans had done running the country,horror at the prospect of Sarah Palin in any position ofresponsibility whatsoever, and I'll admit, I was captured by therhetoric. I thought his speech after the Jeremiah Wright controversy was brilliant. Given that it was clear that the country was in forsome serious trouble as the financial crisis gathered strength I feltthe country needed some inspirational leadership and I thought Obamamight provide it. In the back of my mind I was aware that his resumewas remarkably thin but he seemed so much brighter than most otherpoliticians I felt that perhaps he would grow into the role and Ihoped that perhaps he might be a transformational character. Havingadmitted this I'll also have to admit that I have been disappointedwith his policies generally. I'm to the left of Obama on healthcareand pretty far to the right of him on economic policy. Thus I was notsurprised by the lack of policy initiatives that I thought might beeffective. I was surprised by the political nature of the speech.

First of all was the setting. He didnot address the nation from the Oval Office but instead called ajoint session of Congress and initially tried to schedule it toupstage the GOP debate. The speech itself was not so much an addressto the American people as a harangue of Congress, specifically therecently elected Republican freshmen who have been taking thePresident apart over the budget. Indeed, the speech was delivereddirectly to them, the President said “Pass this bill, pass it now”or derivatives thereof ten times in the course of the speech. Whatreferences there were to the actual citizens were stage whisperedasides about how the government works for the people and the peopleare unhappy with the government. So, why would you get up in front ofCongress, present them a bill whose merits you claim are selfevident, and then demand ten times that they pass it in front of atelevision audience of the voters? It seems like an odd set up to mebut there you have it.

The speech itself had some interestingmoments. My favorite was when he mentioned Lincoln's support for thetrans-continental railroad as an example of a Republican going aheadand putting public funds to good use. The speechwriter was probablynot too familiar with the corporate history of the Union Pacific. Itwas at the center of what was probably the largest corruption scandal in the history of the federal government. The authorization bill wasso badly written the Union Pacific was in litigation for nearly acentury, including nearly a dozen Supreme Court cases, over whatprecisely the terms of its obligations back to the government were.Of course, several private transcontinentals were also built in theyears following the Civil War. The UP was however an outstandingsource of campaign contributions to Congressmen, judges and statelegislatures, particularly when it was in the hands of Jay Gould whotried unsuccessfully to resolve the legal disputes through massbribery. So at least from the perspective of the legislators on thereceiving end of this largesse it was a major success. Not the kindof thing I would put in a speech though.

I also liked how Obama could in onesentence frame his opposition as on the side of “millionaires andbillionaires” and himself on the side of “teachers” and “ourkids” and then in the next sentence say “this is not classwarfare.” It's me and the teachers against the Republicans and thebillionaires? If that's not a reference to class strife then I don'tknow what is. Still, it was artfully done and I think the Republicanshave done an atrocious job of explaining their position. I also thought that he might have wanted to do some more research around his rejection of "the idea that we have to strip away collective bargaining rights to compete in a global economy." Surely the Democratic Party, the annual recipient of hundreds of millions of dollars in campaign contributions from unions, must have noticed that the only places where unions continue to thrive are in services and the public sector. Of course service employees and the public sector are not subject to global competition. Union membership in the traded goods segment has been totally obliterated in the last 30 years. Obama himself presided over the most spectacular example of this when US automakers with their UAW workers had to be rescued by the state while the non-union automakers in the South kept right on going.

In any case, the main event of the speech for me was the rhetorical bait and switch around how the AJA will bepaid for. He led strong with “Everything in this bill will be paidfor. And here's how.” At this I was on the edge of my seat. Thehard part of leadership and governing is not giving away tax breaksand entitlements but figuring out how to pay for them, and now Obama,the responsible leader, is going to do just that. Thank God, butthen.... “Theagreement we passed in July will cut government spending by about $1trillion over the next 10 years. It also charges this Congress tocome up with an additional $1.5 trillion in savings by Christmas.Tonight, I am asking you to increase that amount so that it coversthe full cost of the American Jobs Act. The agreement we passed inJuly will cut government spending by about $1 trillion over the next10 years. It also charges this Congress to come up with an additional$1.5 trillion in savings by Christmas. Tonight, I am asking you toincrease that amount so that it covers the full cost of the AmericanJobs Act.”

What?Wait a minute.So his big idea for how to pay for it is to ask the Congress tofigure it out for him? Hold on a second, didn't he do that back inFebruary when he decided not to implement any of the recommendationsof his own deficit cutting committee and sent Biden to theCongressional negotiations for the first three months thereby cedingthe initiative to Congressional Republicans? Yes, he sure as helldid. How did that work out? Hmmm.... let me think..... Oh, now Iremember the freshmen GOP Congressmen crucified him with the debtceiling fiasco, nearly put the country into default and in so doinggot the credit of the country downgraded. What's more that fiasco wasonly averted by the eleventh hour deal the President refers to butwhose terms he wants to change. So at best he's reneging on theoriginal agreement for $2.5 trillion and upping it to $3 trillion andat worst he's totally abdicating responsibility and putting it on thevery people who almost drove us over a cliff in the first place. Whatabout all that talk about how the GOP in Congress were a bunch ofirresponsible kids and the finances of the country need to be handledby “grownups.” So, here Obama gets a chance to take someresponsibility and what does he do? He puts the ball right back inthe court of the kiddies. Seriously, what's behind all this? I mean,the person who knows best what will happen to the AJA in congress isObama himself. If the last time he punted fiscal responsibility toCongress the result was a total legislative fiasco why would he do itagain?

Ihate to say it but I think the answer is that he knows full well thatit will be a fiasco, and that he wins to a Congressional Republicanfiasco. It seems pretty clear that there's little chance that theeconomy improves significantly before 2012. Obama knows that as badas he looked during the debt ceiling debate the Republicans lookedworse. His plan seems to be to go on TV, and in front of the camerasdemand that Congress pass his jobs bill. Never mind that the AJA isjust a diet version of the ARRA. Never mind that the ARRA was not astellar success. Never mind that it still required $1.6 trillion ofdebt finance. These things supply the only coherence the Tea Partypossesses, so Obama is trying to use them to his advantage.

Ratherthan actually formulate how to pay for the AJA he's decided to laythat part of it at the feet of the very people who almost put thegovernment into default rather than borrow more money or raise taxeswhich he knows full well will be necessary if we're going to extendthe ARRA for another 3% of GDP. He also knows that the Republicanbase will not stand for those tax increases or additional borrowingand will hold the GOPs feet to the fire to prevent it. So he knowsthat the AJA will struggle in congress, in fact I think he hopes itdoes. He may even wish for it to go down in flames. Then when indeedthe economy does not recover by 2012 he can say that if only theRepublicans had passed his jobs bill all would be well. And afterThursday the video editors for his campaign ads have ten shots toochoose from of him telling Congress to do what he knows they have aminimal chance of actually doing. No one will remember that theoriginal stimulus was extremely expensive but not very effective.They won't remember that by adding another $550 billion to the $2.5trillion he's reneging on the original deal further eroding hiscapacity to negotiate with Congress anyway. No, they'll rememberObama telling Congress to pass the jobs bill and then congress, ieRepublicans, screwed it all up. For Obama, mission accomplished. Forthe unemployed, not so much.

Itmakes all that gooey nonsense at the end of the speech about theexpectations of the American people sound like a sneer, as if thepeople in the audience are too stupid to notice that he is doingexactly the opposite of what we sent him there to do: takingresponsibility and making hard decisions. Instead, he's handing theresponsibility over to people who have already played chicken withthe economic security of the country just so that he can blame putthem when he's running for office next year. Great.

I recognize that my criticism of the ARRA and the political rather than economic nature of this post obligates me to step up and discuss the economics behind this in more detail, more to come.

Bernanke's silence provokes market thunder, Lagardes thunder provokes market silence.

2011-08-31T19:56:00.000-07:00

My mother used to tell me that if you can't say anything nice then don't say anything at all. I wonder if that aphorism might not have been going through the mind of Ben Bernanke as he wrote the speech which he delivered in Jackson Hole on Friday. In his much anticipated speech Bernanke did not announce any new policy measures. Indeed, he was at pains to point out the limits of monetary policy. In his public statement Bernanke is always extremely cautious about getting involved in policy debates, particularly policy debates which are the responsibility of the US Congress. In his most recent testimony, which happened to be during the recent bitter budget debate, each side tried to corner him into supporting their position and he simply refused to take a side. His actual words were: “I'm not going to tell you what to do, that's your job to decide. That's why you get paid the big bucks.” I love this guy. So for a man so careful not to get into the business of Congress the closest he can get to taking a shot at them is to simply describe the limits of his own power which was the main point of his speech.

He did point out that the recovery was very weak and that there are serious problems in the real economy that need to be addressed with long term policy. Precisely the kind of policy which Congress seems totally incapable of producing. When the markets read this part of the speech, they dove. But then, interestingly for a speech which was primarily about how little the Fed can do, Bernanke also mentioned that the next Fed meeting would last an extra day. Wait a minute? An extra day? Why whatever for, you've just got done telling us that there is little the Fed can do to address the long term structural problems facing the economy. Hmmm.... Perhaps that means you're going to be thinking extra hard about what policy options you have RIGHT NOW while we wait for Congress to sort itself out. Then the conventional wisdom became that the Fed would take some kind of action and the markets have been screaming higher ever since.

The market rocketship got even more fuel when the minutes of the Fed meeting were released on Tuesday. If you recall at the last Fed meeting the policy announcement was that the Fed would keep interest rates at the current low levels until mid 2013, that is they put a date to their “extended period” language. When the Fed releases its decision it also discloses how many of them agreed with the policy and how many dissented. It does not, however, say WHY they dissented until the minutes are released. At the time, I thought the dissenters were more Hawkish about inflation and therefore thought that the easing was unnecessary. I could not have been more wrong. One of the dissenters did not like the nature of the signaling. He felt that the The other dissenters dissented not because they thought monetary stimulus was unnecessary but that the structural factors in the economy were so severe that it might not even do any good and but would contribute to inflation. It was pretty grim.

Strangely this has put the markets in an unusual position. Since mid-summer the markets have come off quite a lot. The decline has been driven by concerns about Europe, the budget debate, the and the downgrade. It has also been driven by negative economic data. The markets are now at a level where the news has a sort of goldilocks aspect to it. If the data shows the economy is strengthening then the markets will think earnings will be better and the stocks should be higher. If the data is bad then the Fed will be painted into a corner by the time of its two day meeting in September and will likely easy monetary policy further in some creative way. Thus the markets have the same response to good news and bad: they go up. So, Bernanke did not say too much but the markets have heard plenty.

At the same time they seem to be ignoring something else, in particular a quite shocking speech given by Christine Lagarde the new head of the IMF. The speech was especially shocking to be because of an argument I got into a few years ago at a University of Chicago alumni event. The event was a talk by a noted Chicago alum about the financial crisis and the role of the state in it. It was an enlightening talk and the Q&A session led to a lively debate. The debate turned to the subject of what the government could have done to forestall the crisis. A man in the front of the room who was extremely critical of the government generally and the Fed in particular said that obviously the thing to have done was to have the Fed order the banks to raise capital in the summer of 2008. The problem by then was clearly one of solvency, not liquidity, that is to say the the problem was not a short term cash crunch but that the banks did not have enough capital to absorb the losses they would take when the sub-prime writedowns had to be taken.

I could see why the man felt this was a good idea but I thought it was totally impractical. I stood up and argued that if the Federal Government announced to the world that the US banking system was in such deep trouble, and indeed it was not possible at the time to know precisely how deep, that it needed a massive infusion of capital that the capital would not be forthcoming. I felt this way because I remember working in the middle east at the time and watching as a parade of US banks sought out capital infusions from wealthy Arabs and sovereign wealth funds. By the summer of 2008, investor appetite for additional bank capital infusions had waned substantially. My argument was that while it would have been desirable for the banks to recapitalize, no one in their right mind would have put their money into a bank if the banks own regulators were so concerned about its solvency that it was being forced to raise capital.

The man at the front of the room turned around and gave me a look of death, he was obviously not someone used to being argued with, and said “Well, they did all raise capital eventually didn't they.” Smug smile. To which I replied: “Yes, from the taxpayers! And the taxpayers only contributed to it because you go to jail if you don't pay your taxes!”

Well this story has two surprise endings. First the man at the front of the room was Cliff Assness the billionaire founder of hedge fund AQR. For the record, I am not a billionaire. The second is that this past weekend, Christine Lagarde, the head of the IMF called for the European banks to be forced to raise capital. In my opinion this is by far the most important thing to come out of the Jackson Hole conference. Far more important than the non-comments by Bernanke. I would even go so far as to say, that, if the speculative attack on the Eurozone is renewed and is successful, people will be talking about this speech for years to come and Christine Lagarde will become a very important historical figure for being ahead of the curve. The response of the ECB and the EU was to deny that this was necessary and the markets have been listening far more to what Bernanke has not said than to what Lagarde did say.

They should listen more closely. More than anything else what has driven the markets lower this summer is the fear that a major fiscal problem is brewing. The US downgrade is part of this but while this is embarrassing for the US it is potentially fatal for Europe. What the markets are afraid of is that the once the ECB is done with its bond purchases, the speculative attack will resume and it will ultimately succeed in bringing down a European sovereign. If this happens there is going to be an ABSOLUTELY MASSIVE banking crisis in Europe. This is because the Eurozone has created a continental market for banks but, because the ECB is has no taxing power, any attempt at a TARP like bank rescue would have to be funded by individual countries. The problem here is that because they operate across the entire Eurozone the banks are MUCH MUCH larger than the countries which would have to rescue them.

In the US the balance sheets of the top 3 banks are about 60% of US GDP. In France, the balance sheets of the top three banks are 600% of GDP. That's right, the top three banks have assets outstanding equal to six times the size of the French GDP. Remember the TARP? That was 5% of US GDP. It was a big number but the US could borrow it. Now imagine a world in which Spain has gone bankrupt and the French banking system is on the verge of collapse so France decides to implement its own TARP, it would have to be 50% of GDP, or put another way, France would have to instantly borrow as much money as it has in the past fifteen years combined. Do you think there is any chance that this would actually happen? No there is not. What would happen is that those banks would fail and would therefore wipe out the savings of their depositors as well as damage any banks to which they owed money. Keep in mind this is not just France, this is the case in every country. So if there is a major sovereign default the European banking system cannot be saved.

Christine Lagarde's idea is to get in front of this and force the European banks to raise more capital from private sources before the storm breaks so that they have a better chance of weathering it. I take my hat off to her for raising it. That said, as was the case with Cliff Asness, I don't think it can be done though for different reasons. The reason that in 2008 the banks could not be recapitalized in practice was that though there was enough money to do it, no one knew what precisely the scale of the problem was. In this case, we do know what the scale of the problem is but not only is there not enough money in practice to do it, there's not enough money even in theory.

Do you think Ron Paul, Michelle Bachmann, and Rick Perry are idiots? Would you like to bet on it? Tomorrow is your lucky day.

2011-08-25T16:53:00.001-07:00

Since my last post there has been quite a bit of excitement in the markets. The S&P 500 has had about a 10% range and has been moving at least a percent a day, often much more. Given these massive moves its hard to ascribe a lot of meaning to the market action on any given day. That said I think fundamentally three things are at work. One, is that the markets are still getting used to the idea that there is no risk free rate. This is a complicated fact for the markets to absorb given how much portfolio theory and how many pricing models rely on this assumption. That said, its a very subtle impact and the markets seem to have adjusted by fleeing relatively risky assets and piling into relatively less risky ones.

The second story is the Eurozone crisis. Though the ECB has, for the time being, successfully pushed back a speculative attack on Italy and the attack on France in light of the US downgrade has also receded most investors are aware that there remain very deep and vexing problems in the Eurozone. Though many of the consequences of a sovereign default of a major country are unknown they would almost certainly lead to a major banking crisis which would be nearly impossible to contain. Though the markets don't know what the probability of this is they know the consequences are very very bad and this fact is weighing heavily on the markets. More on this in subsequent posts.

What optimism there is stems from two things. One is the hope that though the economy is slowing down the market reaction has been overdone and that the economy and with it the markets will pick up, of on their own in the second half. The other reason, and according to some pundits, by far the stronger, is the idea that the Federal Reserve is going to ride to the rescue. This is because Ben Bernanke is set to give a speech in Jackson Hole at the Kansas City Fed conference of Central Bankers on Friday. It was at this conference a year ago that Ben Bernanke announced that he was embarking on a second round of quantitative easing, or as it has been affectionately called: QE2.

Now the Quantitative Easing policy has been controversial to say the least. Where you stand on this controversy will say a lot about whether you think Bernanke will announce further easing on Friday. Virtually all of the Republican Presidential candidates have come out against Quantitative Easing. Just last week Rick Perry called the policy “treasonous.” Ron Paul, who has made himself heard on this subject repeatedly not only opposes Quantitative Easing but the entire Federal Reserve System and, for good measure, the whole concept of fiat money. Naturally someone who believes that we should return to the gold standard is not going to be a fan of creating reserves in the banking system and using them to purchase Treasury bonds with them. Michelle Bachman has also come out against Quantitative Easing though, if you ask me, not with a particularly coherent objection. It may be silly to call a monetary policy tool “treasonous” but at least you know where the guy stands even if his reasoning can best be called “obscure.”

It is worth taking a look at the arguments that these men and other opponents of QE make because, whether you agree with them generally or not, there are indeed good arguments to be made against it. Opponents of QE have two main objections. The first is that QE is an enabler of government profligacy. That is to say that the fact that the Federal Reserve is creating reserves (printing money) in the banking system and using those reserves to purchase US government securities is creating artificial demand for those securities and as a result is lowering the cost of borrowing for the government. This of course just encourages the government to borrow more than it would otherwise. While it is true that QE does marginally lower the rates at which the government borrows it is not clear to me that it follows that this creates more borrowing. The level of government borrowing is a function of the budget process which is well in the hands of congress and I don't think that the level of interest rates has been of much concern to Congress with regard to those decisions for at least a decade. In any case, even without QE interest rates are at a level which would be unlikely to deter borrowing anyway so I think this is a weak argument.

A more compelling argument is that money creation is well known to be inflationary. Historically countries which have found themselves creating money in order to finance public spending often fall into an inflationary spiral which often has devastating consequences for the country. This is because the artificial creation of money in the hands of the state tends to devalue all the real goods and services in the economy in terms of that currency. That the more money there is the lower its value in terms of actual goods and services and therefore the price of everything goes up. This erodes the savings of the thrifty and devalues the debts of the levered. It also causes massive dislocations in the economy generally. Latin America is littered with examples of this and the recent example of Zimbabwe going over the hyperinflation cliff has once again served as a warning to the world. Of course the most politically momentous monetization of government obligations occurred in Germany in 1922. The subsequent hyperinflation obliterated and then radicalized the German middle class and laid the groundwork for the capture of the state by the Nazi party. So to say the least, the historical record for debt monetization (printing money to finance government spending) is not great.

So the Tea Party guys are not crazy to raise objections to quantitative easing. Given that they think the primary motivation behind it is to facilitate additional government stimulus when the economy slows down it is not hard to imagine why they might think that a fresh wave of it is on the way. GDP growth has been much slower than planned, consumer sentiment is weakening and many economic indicators have come in much weaker than expected or hoped. A few weeks back the Fed revealed that its outlook for the economy has darkened significantly and announced that it would maintain its extremely low interest rate policy through 2013. Given this, it is easy to see why many people expect some kind of announcement of further policy action by the Fed come this Friday and since they hate the idea they are up in arms. On the other hand, stocks are priced in dollars and so, in the event that the Fed announces QE3, their prices are likely to rise which is why many think we have come off the bottom despite continuously grim economic data.

Personally I have a different view of this. While I am not a fan of printing money generally and I am very aware of the historical record I think that, at least in the hands of Ben Bernanke, Quantitative Easing is not to be feared. The reason is that Bernanke had a very specific reason for engaging in QE last year that had nothing to do with a desire to fund the US Treasury more cheaply. The thing to remember is that just as money can be created it can also be destroyed and what Bernanke was doing was making up for monetary destruction.

As mentioned the Federal Reserve Bank creates money through quantitative easing but because the US banking system is a “fractional reserve” banking system the commercial banks are able to create money as well in the course of taking in deposits and making loans. This is because they are only required to hold some of their deposits in reserve (ergo “fractional reserve.”) This is why banks are able to operate with such extraordinary leverage. Banks are also required to have an adequate equity capital cushion in the event of losses so that the equity holders take the losses before the depositors do.

The trouble is when banks take a large losses over a short span of time as they did during 2008 they erode that equity cushion and this means. Since the equity cushion has to be repaired before banks can engage in new money creation large losses shrink the money supply. This is why the Fed embarked on QE1. So the collapse in housing prices has forced the banks to take recognize huge losses on their balance sheets but, as large as those losses are, the markets believe (and are probably right) that there are still far more losses yet to be taken. A year ago this fear and the weakening of the US economy led people to believe that there would be so much monetary destruction that there in the future not only would we not have inflation, we would have its opposite, deflation. Now, as bad as Ron Paul and Rick Perry think inflation is, the thing that scares the hell out of Ben Bernanke is deflation.

This is a little counterintuitive. It's easy to see why inflation is bad, if you want to buy something and the prices are always going up and going up fast its easy to see how this harms you. On the surface it seems that a world in which the prices of everything were always going down would be good, everything is always cheaper so one can buy more of it with the same funds, everybody wins no? No. The thing about deflation is that it doesn't so much function as a permanent sale but as a permanent deterrent to every buying anything. Imagine if everything in the world was always getting cheaper, then you would only buy the things you absolutely needed right now and you would defer all other purchases. Deflation is a HUGE buzz-kill for economic activity. Not to mention that it has the effect of obliterating the solvency of large debtors and the US government is the largest debtor on Earth.

So, seeing deflation on the way last year Ben Bernanke warmed up the printing presses and launched QE2. This sent the stock market higher and whipped cured the deflation problem well and proper. So here we are in the future and not only is there no expectation of deflation, people are concerned about inflation. If the Fed were to engage in Quantitative Easing right now the fears of Ron Paul and Rick Perry and the hopes of the stock market would be fulfilled. This is what gives you an opportunity to bet against Ron Paul and Rick Perry. If you think Ben Bernanke is just part of a nefarious plot to load up the country with debt then you'll probably think he'll embark on QE3 tomorrow and if you do think that you should buy the markets with both hands. If you think that Paul and Perry are all wet and there's no way that Bernanke will do any such thing then you might want to be short going into Bernanke's speech tomorrow. Well, Bernanke speaks at 10AM New York time tomorrow so you'll have 30 minutes to place your bets.

What do Rowan Atkinson's MacLaren F1 and Bernanke's Equity Rally have in common? I'll give you one guess.

2011-08-10T16:06:00.001-07:00

Whoa, I guess I was more right than I thought with my article about how yesterdays rally might be short lived. This was on account of a renewed speculative attack in the Eurozone this time focused on France. I hope to publish on this sometime before midnight tonight. Sorry for the brevity, this is an interim post.

Forthcoming Post: The Return of the Bond Vigilantes

Thank you friend reader for your unseen but ever-felt presence.

FOMC ANNOUNCEMENT UNLEASHES AN UP-CRASH! TO INFINITY AND BEYOND!....or maybe not.

2011-08-10T05:50:00.000-07:00

Before I talk about yesterday's action I want to tell you a story.

Back in September of 2007 I was the Global Head of Business Development for what I will call “a large foreign bank.” It sounds impressive but in essence I was “Mr. Fixit” for the guy who ran equities. The thing that needed fixing most at the time was the DIFX, a stock exchange in Dubai owned by one of the largest shareholders in the firm I worked for. MENA was covered by the Emerging Markets group and so whenever I was in London or New York I hung out with the EM guys. We were in the middle of what we knew was likely to be the best bonus year in the history of Wall Street. 2006 had been outstanding and 2007 was blowing it away. Given the events of 2008, it's easy to think of the summer of 2007 as a kind of idyllic past, like June of 1914 or August 1939 and in truth, it was. Of course it didn't seem that way at the time. The trouble in the real estate markets had already begun. Though people were still thinking of how to spend their bonuses, I was contemplating a certain watch at the time, people were getting the sense that the gig was up.

I like to think that the financial crisis officially began on my birthday. On June 7th, 2007 Bear Stearns halted redemption from its High-Grade Structured Credit Strategies Enhanced Leverage Fund. That fund would be wiped out entirely in less than six weeks and in the first week of July S&P put 600 subprime ABS on negative watch. Then in August American Home went bust, and in September the Bank of England halted a run on Northern Rock, the first bank run in England in over a century. People were starting to freak out and the markets started to sell off. The S&P 500 fell from about about 1550 to an intraday low of 1370 in a week and a half, which given recent events, may not seem like much, but considering that it took the market the whole of 2006 to go up 140 points it felt like a big scary move at the time. People were scared, a friend of mine in New York called me at 3AM Dubai time and told me about a meeting he had with our firms asset backed credit traders about the default cascade that could be initiated by the seizing up of the credit markets that caused me to ring up my parents and suggest they move their retirement savings to cash. It was that kind of scary.

Then as now, all eyes were on the government especially after the Northern Rock fiasco in the UK. The Fed had come out and said it would ensure the liquidity of the banking system (back then it still seemed like a liquidity issue rather than a solvency issue) but took no action. Then on September 18th, the Federal Reserve cut the Fed Funds rate from 5.25% to 4.75%. Whoa! 50 basis points in a day? Hallelujha! Daddy Bernanke is home he's gonna make it all right. The markets positively screamed. The S&P jumped 50 points in a single day, think about it, six months of price action in 2006 in a day! Woo Hoo! Happy days are here again, we're all going to get paid after all. Pop the champagne!

I remember September 18th 2007 very clearly. At the time I was commuting between London, New York and Dubai and I had been spending the past week and a half in London putting things together for an IPO we were doing in Dubai so I was sitting in my desk on the EM trading desk. Even though I was a management person I always felt more comfortable on a trading desk. I'm sure it annoyed all the actual traders to have an ex-trader management guy on the dest but nostalgia is a powerful drug, sitting on the desk allowed me to relive my youth. At the time I considered myself an old salt, having traded through the Russian default crisis, the LTCM collapse, the internet boom and bust, September 11th. In a young mans business at 34 I was a seasoned veteran. The guys on the desk were on edge because the VIX, an index of volatility, had popped from 18 to 36 in a day. I could remember a time when it stayed above 40 for months at a time. Yep, I had seen it all (rueful smile.)

All that summer I had been telling people that things felt a lot like they did in 1998 during the Russian Default Crisis and the LTCM debacle. The internet collapse was different, everyone knew it had to happen they just didn't know how far it would fall. In the summer of 2007, unexpected things were happening all the time and people were generally worried. They knew there was a problem and though they did not know how big it was, they knew they did not know. Then on September 18th, something that seemed normal happened, the Fed jumped in with an aggressive rate cut and language saying they would supply all the liquidity necessary and the markets absolutely screamed higher. I stayed in the office through the New York close, 9PM in London watching the markets rally. My eyes were popping out of my head. At the end of it the guys and I were just staring at the screens dumbfounded. Knowing what we knew about how deep a mess the markets were in, we simply could not believe the size of the rally but there it was, mocking our “knowledge.”

After the bell rang in the US I stood up and shouted to the trading desk, “Boy, what a relief! I'm sure glad the crisis is over.” The desk erupted in laughter because, in our heart of hearts and no matter what the screens said, we knew it had just begun. Indeed, two weeks later the S&P touched 1575, its all time high and then things came apart at high speed from then on.

I tell this story not to compare recent events in the markets and the Great Crash of 2008. There are a lot of comparisons between the two being made now but I think it best to defer to the principle of Heraclitus: a man never crosses the same river twice because the river is different, and so is the man.

Instead I tell it as a warning of how difficult it is to interpret market moves, especially extremely violent one as we have had these past two days. Monday was had an extremely violent crash that got relentlessly more violent with every bit of news that came out culminating in a vertiginous plunge that began during Obama's remarks. This seemed to present a straightforward vote of no confidence by the markets ini risk assets generally and in the will of the American political system to address itself to the most serious challenge that the Republic has faced in a long while.

Yesterday, the day began with a relief rally that gathered steam until about noon and then lost steam, trading back down to flat into the moments before the Federal Reserve Statement. The Fed Statement was, in a word, grim. First of all, it acknowledged that the economy was slowing appreciably which is most certainly is. It also acknowledged that the slowness is not merely the result of supply chain disruptions from the Japanese earthquake and pressure on consumer spending driven by commodity spikes which are traceable to political events in the Middle East and therefore temporary. It also mentioned that though long term inflation expectations were stable short term inflation had indeed risen from the beginning of the year. This is key because the markets have been cheering for a resumption of Quantitative Easing, something which cannot happen unless long term inflation expectations diminish substantially.

Instead of announcing QE3 then the Fed announced went a bit further in the direction of defining what precisely it meant by “an extended period.” The Fed has been using that phrase for some time to describe how long they plan to maintain their easing stance. They do this to try to give reassurance and yet provide some ambiguity within which the markets can adjust. Yesterday they said that they intended to maintain the current stance until mid 2013. In economic terms that's a REALLY long time. Interestingly there were also 3 dissensions from the policy statement. Meaning that almost half the Board did not agree with the statement. We don't know why they objected, they might have been against the continued easing or simply against the idea of the Fed telegraphing its intentions for so far in advance.

Personally I read this as the Fed being seriously concerned that the economy is slowing, that fiscal stimulus had not only failed but, given the deficit issues the country faces, unlikely to be attempted at least unless and until the 2012 elections provide a meaningful mandate one way or the other. The Fed also recognizes that in the current environment commodity prices have been high for a persistent period and are therefore beginning to be priced into final products and being transmitted into core inflation. This is a major challenge for them because it means they cannot engage in Quantitative Easing without seriously stoking inflation. So they're making the best of a bad position and telling people that though the Fed won't be growing its balance sheet, it also won't be shrinking it any time soon either and you don't have to worry about increases in interest rates for years. As I said, it was grim.

It was actually pretty hard for the markets to digest. The first thing they did was to read the economic prognosis and note the lack of QE and the high level of dissent and dive for the deck. The S&P dropped about 20 points to 1100 or so, down 50 points form the high of the day. Treasuries rallied hard and gold, which was already higher on the day jumped another $30. Actually I think I should just stop commenting on gold, just assume that whatever happens, gold is up $30. OK?

Then something interesting happened. The market turned on a dime and leapt higher by 4%, hung out near the highs of the morning, and then in the last 30 minutes of the day screamed higher by another 3% giving the day almost an 8% range. I think would be fair to call what happened an “Up-Crash.” Do not pass go, do not collect $200 go straight to the moon, the devil take the hindmost and for good measure let's crush the hell out of any lingering short sellers who will panic and get out because they know Asia will follow this rally. The rally was so strong it basically brought us back to where the equity markets opened before the S&P conference call and the Obama statement of the day before. It was as if none of the bad news ever happened.

As an observer its actually pretty hard to know what exactly happened in the last hour of trading. Maybe the markets thought that keeping the balance sheet high and maintaining Fed Funds at Zero through 2013 was likely to provide a similar level of monetary stimulus to QE and so they jammed higher on a sense of renewed monetary easing. Maybe but if that's what happened then its pretty hard to explain why in the last hour of trading gold dropped $40 in the same period of time. At the same time US Treasuries fell out of bed as well.

Yes, it is extremely hard to explain which is why I draw your attention to the rally in September of 2007. Yesterday was an up-crash: a panic rout of buying just as frenzied as the panic rout of selling the day before. It is extremely hard to discern what this means about the future direction of markets. It does speak volumes about the level of uncertainty in the markets that they from day to day they cannot agree as to what the total value of US productive capacity is to the nearest trillion. In the final analysis, the important thing is not what I can tell you about what happened between 3:30 and 4PM yesterday. It's what I can tell you did not happen: in the last 60 minutes of trading on Tuesday the entire global financial system did not rationally think though the implications of the S&P 500 downgrade and decide that it did not matter after all. It does matter and it will take more than two days for all of the implications to be fully explored by the markets.

Things are interesting and they are going to stay interesting.

Gotterdamerung: S&P pours fuel on the fire, world leaders struggle to put it out

2011-08-09T06:28:00.000-07:00

Sorry for the delay. I hosted a dinner party last night so I could not get straight to writing. I'll just go over the market action yesterday and the major news that drove it.

Of course the top story was Friday's downgrade. As I mentioned in my Sunday night post I did not think that the markets had absorbed the possibility of a US downgrade and it would seem that they had not. So Sunday night the markets in Asia started us off with a respectable sell off and, once the CME overnight trading portal (GLOBEX) opened, T-bonds sold off as well and the Euro rallied though both of these moves had reversed themselves by the London open.

The ECB Counter Attack

So, as I mentioned in my post of last Friday, after the European close on Friday the Italians announced that they had negotiated a package of reforms with the European Central Bank that would push forward thier fiscal consolidation, would free up the labor markets and amend the Italian Constitution to balance the budget. This, it was theorized, would enable the ECB to add Italy to its program of bond buying. Indeed, yesterday morning the ECB leapt into the European bond markets with guns blazing.

Buying Spanish and Italian government bonds in $50 million clips the ECB was able to jam the yields on both of them to around 5.5%, well under the 6% danger zone that most investors consider unsustainable and where they have recently been. This encouraged markets in the European morning and they actually rallied off the Asian lows. London actually opened higher but the joy was short lived. While it was true that the ECB was able to jam Spanish and Italian bonds below a 6% yield, German bonds remained remarkably well bid.

This is important because German bonds in Europe are considered the local safe haven. In order for things to return to “normal” it is not enough for Spanish and Italian yields to drop, money has to come out of Germany and into the riskier economies. The stubbornly low German yields indicate that investors are not selling out of Germany and are therefore not following the ECB into Spanish and Italian paper. Even more disconcerting was the divergence of France from Germany. France and Germany are considered “Core” Europe. Those crazy sun addled Mediterraneans and the Guinness besotted Irish may indulge in absurdist levels of debt to GDP but France and Germany are viewed as above the fray. Well, once the US went over the AAA cliff on Friday, investors have been taking a hard look at France and do not like what they see. So while the ECB counterattack against the speculators in Spanish and Italian bonds was a major tactical success, at the strategic level things remained touch and go. Not a good sign.

The S&P Conference Call

Yesterday morning S&P held a conference call to discuss the US downgrade from Friday. S&P has come under some criticism for its downgrade. The US remains the most solid credit on Earth. This could be seen by the fact that within a few hours of the GLOBEX open USTs had reversed their decline and were headed higher. There is also the widely reported “$2 trillion error.” On the face of it, it's not hard to laugh at S&P's assertion that the error is not material because well, 2,000,000,000,000 is not a small number. The really depressing fact is that when thinking about US indebtedness it actually is a small number. The difference turned out to be whether the US would have a 86% or 92% debt to GDP ratio in 2022. As it turns out, either number is high enough to cast serious doubt on the long term credibility of the US and would easily justify the ratings cut so S&P is actually right in this case.

Even so, they were VERY aggressive on their conference call. Yesterday they downgraded several thousand other borrowers who are dependent on the US Treasury for income including Fannie Mae and Freddie Mac, the real estate holding companies backed by the Feds. They also downgraded Israel because, believe it or not, the US guarantees Israeli sovereign debt. This would have been grim enough news on its own but they went further than that. They said that they were many other AAA and AA+ credit in the world with a view to reorienting the worlds risks given the lower rating they assigned to the US. They did this with particular reference to US States, specifically US states which are heavily dependent on federal spending and transfers. There was a Q&A session in which many of those on the call attacked the S&P methodology. S&P was dismissive of it's critics and very assertive about its decision to downgrade the US, to keep it on negative watch and to look deeply into all its other ratings in light of the US downgrade.

This is of course a fiasco for two very specific sets of borrowers: European countries and US states. To have the ratings agencies reconsider all Europe in light of the US downgrade in the middle of a speculative attack is a serious blow. The idea that no European country at the AAA or AA+ has a safe rating is a shot across the bow of “core” Europe. Remember the mechanics of the EFSF, it functions essentially as a wealth transfer from the “Core” European countries to the periphery but calls on ALL European states for contributions. It in effect blurs the balance sheets of all the European countries and many of the commitments are so large that, if fully drawn down, they would significantly worsen the debt to GDP ratios of all Eurozone states. In addition to this, the level of cooperation that will be necessary at the EU level in order to fully fund or amend the functioning of the EFSF will be so fraught it will make the US debt ceiling debate look like the instant consensus of philosopher kings in comparison. This is likely to make the respite bought by the ECB counterattack remarkably brief.

In addition they put the US states on notice. This is a pretty serious problem. It is well known that the pension obligations of the US states are absolutely massive and that generally the financial position of many US states is extremely precarious. This is very interesting because, unlike municipalities, there is no bankruptcy code for states. In the event that a state went into default it would have to negotiate with its creditors almost as a sovereign but within the confines of federal law. Congress considered writing such a law but decided against it because it thought a significant number of states would file for bankruptcy immediately if such a law existed and this would raise borrowing costs for all states.

S&P downgrading a state on the back of the US downgrade would have immediate and serious consequences. The US sovereign has had its borrowing costs lowered because it is still the safest borrower on Earth and so has benefitted from a quasi-paradoxical flight to quality in the light of the downgrade. Will the same effect occur if California or New York are downgraded? Hell no. Their borrowing costs go up immediately which would have the effect of widening the fiscal gaps which drove the downgrades in the first place. What's more is that the states are, like Europe, looking at multiple simultaneous downgrades. This means that investors will not be able to switch from one state to another with confidence and may simply flee the municipal bond market entirely selling the safe and the risky, raising the funding costs for all.

In the event that there is a downgrade cascade that leads to a default cascade the US will be plunged into a VERY interesting but also VERY serious political crisis. It is widely assumed that the Federal government would step in to rescue the states in the same way that it did the banking system. I think this is unlikely to happen and that, if it comes to it, the State defaults will be extremely messy. This is because such a bail out would be extremely politicized. First of all the fiscal gaps the states are facing over time as their pension and health obligations increase with the retirement of the baby boomers are, across all the states, on the order of hundreds of billions of dollars. Trillions if you go out far enough in your calculations. Given the massive battle that just went on you can imagine the appetite in Washington for taking on more debt from the states is nil. Then you have to consider the opportunity that a cascade of state bankruptcies would present the Republican party.

The largest expense of any state is the salaries and benefits of its public employees. These employees are, by and large, unionized. Therefore they collect dues and use them to finance political campaigns of pro-union politicians, that is to say, Democrats. Public sector unions contribute over $100 million a year to the Democratic party at the federal level and several times that at the local level. A cascade of state bankruptcies which forced the states to seek funds from a federal government in which the House of Representatives are controlled extremely financially conservative Republicans presents an incredible opportunity to destroy a major source of Democratic campaign finance. Do I think the GOP is willing to play politics with this? Given that they were willing to put the country into default over much less, there's not a doubt in my mind.

Obama's speech

Naturally the United Sates can't take the downgrade lying down so Barak Obama planned to make a statement at 1PM. This was delayed until 1:30. It's a sign of how rapidly the markets are moving that the S&P 500 dropped a percent and a half during the delay. In the event the markets were not comforted by Obama's remarks.

Obama said that the US is still a AAA country and he quoted Warren Buffet as saying that there should be a AAAA rating and the US should have that. He then said that the main issue was not whether the US could pay or whether there were ideas about how to cope with the deficit but that the main issue was the political infighting. He said that all that was necessary was to make minor adjustment to medicare and to make the wealthy pay their fair share. He then called for unity and said that America would get through this and then made a reference to the deaths of the Navy Seals over the weekend in Afghanistan. The moment he said the words “Tax reform that will ask those who can afford it to pay their fair share and modest adjustments to health care programs like Medicare” the markets started dropping and plunged two more percent, had a last gasp rally and then closed on their lows.

When interpreting something like this it is very hard to speak for the markets without actually speaking for yourself. At this point I should admit that my market analysis is heavily formed by my own views. I think the markets sensed that Obama does not understand the depth of the problem he is facing. The markets are now fully alive to the scale of the US debt crisis and it is massive. Under the optimistic CBO projections which include the repeal of the Bush tax cuts and the end of the wars in Afghanistan and Iraq the federal debt grows by $10 trillion in the next ten years. If you look out over the next 30 the fiscal gap is in the high tens of trillions. This can not be solved by “asking those who can afford it to pay their fair share” or making “minor” adjustments to medicare. Think of it this way, this year the deficit is $1.6 trillion. The US collected around $1.1 trillion in income taxes, $650 billion of this came from the top 10%. So if you DOUBLED the taxes on the top 10% of income earners, which by the way not even the Democrats are actually suggesting, you close only a third of the deficit. That is to say, the problem is vastly greater than the simple solution of raising taxes on the rich.

Do you notice how in the debates no one ever actually refers to the data? They prefer comfortable sounding phrases like “make the wealthy pay their fair share.” That is, yes Mr. & Mrs. John Q. Public, there is going to be some pain but it won't be borne by you. The markets no longer buy it. To actually solve this problem is going to require very real pain across the whole of society. The debt ceiling debate showed how difficult it is to get a trivial amount of deficit reduction passed. In my opinion Obama's insistence that there isn't really a problem with the rating, and that what problem there is can be solved relatively painlessly if people agree to cooperate doesn't hold water. The reason people cannot cooperate is that the pain that will have to be borne is very real and they don't want to bear it. Until the politicians admit this to themselves and then to the voters we are going to continue to struggle.

And though we may get a relief rally today I don't think the fallout from the US is over by a long shot and my next few posts will describe what think will unfold in the coming weeks.

Don't worry darling, AA+ is the new black.

2011-08-07T15:16:00.000-07:00

Of course the big news for he coming week is the S&P downgrade of the United States long term credit rating from Aaa to Aa+ with a negative outlook. To hear the financial press tell it, this is no big deal. AA+ is the new AAA, the new flight to quality assets are the old flight to quality assets or, as they say in fashion, black is the new black.

The arguments in favor of this take several forms. One is that the markets have largely priced this in. Another is that, the credit rating notwithstanding, the vast majority of holders of US Treasuries will continue to do so. Thus there will be no panic sell off in the US Treasury market and the impact on the funding costs for the US government may be muted. They also point to the example of Japan, another country which lost its AAA rating without a significant impact on its borrowing costs.

I think these arguments have some merit but I think the conclusion they reach is far too sanguine. I think this is the beginning of what will be a systematic repricing of risk assets which will demand higher returns and thus push asset prices lower.

I think the argument that there will not be a fire sale of US sovereign securities is correct. The largest holder of Treasuries are the government “Trust Funds” for Social Security and Medicare which should themselves be the subject of a blog post. Once the government realized that it would in no way be able to pay for future entitlement programs on a pay as you go basis on account of demographic changes it decided to try to minimize the burden on future taxpayers by charging an excess to current taxpayers. A reasonable idea except that the Trust Funds are mandated to be invested fully in US Treasury securities. That is to say the government lent the money it is saving back to itself to pay for programs today. Who has to pay these loans back? The very future taxpayers the government was trying to spare excess taxation in the future, more specifically, if you are a US national in the prime of your working life: YOU. Nonetheless, the Trust Funds are unlikely to sell their Treasuries.

The second largest holder is the Federal Reserve which owns a lot of Treasuries as a result of its program of Quantitative Easing. It won't be selling either. The next batch of Treasury holders are foreign Central Banks the largest of which manage their exchange rates vs. the dollar by sterilizing capital flows between the countries in order to enhance the competitiveness of their domestic manufacturers. These banks are sure as hell not going to sell their Treasuries because it would mean their industries would have to compete on a level playing field with the United States, they have no intention of ever letting that happen. Next in line are world financial institutions who hold Treasuries as part of their securities portfolios and often pledge them as collateral to their own central banks or to the various clearinghouses around the world which intermediate the financial system. This weekend the Federal Reserve said that it would not adjust the risk weighting on Treasuries which would have forced all the banks in the world to raise capital. Finally there are the worlds money market funds. They will not be forced to sell their T-bills because the short term US credit rating is unchanged. The only people who will be forced to blow out of their US Treasuries monday morning, or rather Sunday night when Globex opens will be money managers with a hard AAA mandate that cannot change it in time to allow them to continue to hold US Treasury securities. Within the universe of $11 trillion in outstanding US paper, these are not a lot of guys.

So the argument that there will not be a wave of forced selling in US government paper holds water. The idea that the markets have this priced in I think is a lot harder to take. It's actually pretty hard to speak for “the markets” but given that longer dated T-bonds jumped about 10% in the past week I certainly get the sense that investors were thinking that the US government was a lot safer a bet than virtually anything else they might have put their money into. As you could see from the market action on Friday the markets have been far more focused on the sovereign issues in Europe than in the US.

I also think the Japan analogy breaks down both on the fundamentals and the timing. Japan has a very high savings rate and virtually all JGBs are held domestically. As a result Japan is reliant on relatively tame domestic buyers to fund its debt and deficit. This is not even remotely the case for the US where around half of our debt is held by foreigners and, because of our extremely low savings rate we are very dependent on the marginal foreign buyer to fund the deficit and maintain the price of Treasuries. Then of course there was the context of the Japanese downgrade. This was back in 2001, true we were in a recession brought on by the collapse of an asset bubble but the banking system had not had a recent near death experience. There were not also multiple simultaneous speculative attacks against major OECD sovereigns. No, I think the US downgrade is likely to have a substantial impact.

It may just be that the impact is not on US Treasuries themselves. As the optimists in the financial press have been quipping the downgrade of US Treasuries might lead to a flight to a quality into... US Treasuries. As mentioned, black is the new black. That may well be but it is cold comfort for what S&P has just done is make it official that the US Treasury can no longer be regarded as a proxy for the risk free rate. It may well be the least risky thing out there but all that is saying is that every other asset in the world is also riskier than it was when Treasuries were risk free and therefore should be paying a higher return. If they should be paying higher returns that means that they should be priced lower. This is what I think will happen, a systematic repricing of risk assets the world over to take into consideration that the US Treasury, and therefore the anchor of the global financial system in general, is actually much riskier than has been assumed for most of the past 60 years or so.

I expect this to manifest itself in renewed, and far more aggressive, speculative attacks in the Eurozone, and not just the periphery. If the US is not AAA then surely France, Germany and the Netherlands, the core of the Eurozone are on shakier ground than was originally thought. If they are on shakier ground then what hope can there be for Italy and Spain, who will be reliant on them in the event of a major fiscal problem. If Spain and Italy are in trouble what hope can there be for Greece, Portugal and Ireland. I think there will be a renewed speculative attack across the Eurozone periphery and perhaps an attack on the Center itself. In the event that such an attack succeeds, the European banking system will take a major hit to its balance sheets at the same time as the Eurozone governments are under attack from their bondholders. Keep in mind that the European banks are all much larger relative to their governments than are US banks. A European style TARP would be almost impossible to initiate so a sovereign crisis in Europe that spread to the banking system could not be contained and would quickly spread to the rest of the world.

A major and durable correction in risk assets would probably also deter both consumption and investment decisions in the US which may well tip an already fragile economy into back into recession. Bond markets will also have to begin to wonder about the credit worthiness of all US corporations. After all the rhetoric is that the way to plug the fiscal gap is through increased taxation on businesses and capital which will systematically raise the costs on American business. Whatever impact this may have on future profitability there is only one direction for equity prices to go in order to take this additional risk into consideration: down. Additionally, the fiscal problems facing state and local governments are going to become much more acute as their ratings are also going to be in trouble and while there is no precedent for a US sovereign default there is a LOT of precedent for municipal default. Municipal default can also cascade if investors generally flee municipal securities.

So in short, the financial press may be right. AA+ may well be the new black. The finances of the US Government may not be too affected in the end. The problem isn't really there. The problem is that if what was once considered riskless no longer is, then everything risky should be paying more than it was. I think it will take the markets a period of weeks to absorb the new risk paradigm and in that time the instincts of the market will be to flee risk assets and reprice risk generally. The timing of this is not particularly helpful because of the multiple speculative attacks in Europe and the fragile US economy. So the US Treasury may not wind up paying higher rates, at least initially, but everyone else in the world may and this is manifestly not helpful.

AA+ may be the new black, but we had better prepare ourselves for the mean reds.

Todays Rally-Crash-Rally-Unchanged brought to you by THIS GUY

2011-08-05T14:56:00.000-07:00

Yet another fascinating day in the markets.

So, this morning before the bell we got the employment report. The economy created 114,000, of which 154,000 were private sector jobs (the government net fired people.) This allowed the unemployment rate to tick down a point to 9.1%. Not a great report but it did beat expectations and, given the massive crush of selling into the close yesterday the market opened with a very healthy pop. Immediately after the open the S&P was up 17 points or about a percent and a half. This was as high as it was to go however as investors quickly remembered that employment is a backwards looking number while the other negative data from the week, ISM manufacturing and non-manufacturing were forward looking and very weak. Also, there was no news out of Europe and though the European credit spreads were easing a little, taking the pressure off the troubled governments on the Southern rim, there was still no policy news that would put the market at ease. Add to this that there is still a lot of doubt as to whether the US will maintain its AAA rating and investors decided to take advantage of the employment bounce to get out while the getting was good.

In the first 20 minutes of trading the S&P dropped 30 points or just over 2%, a small move compared to the disaster of yesterday but a large move on any other day. The market then alternately drifted or plunged lower until about 12 noon New York time, at which time it bottomed at 1169. Treasuries which opened lower after yesterdays spectacular rally also traded up almost immediately after the open. Keep in mind that when Treasuries trade higher, they imply lower interest rates. Gold also spiked up about $20 as investors continue to fear all sovereign risk and consider gold the last best safe haven.

Then, a little before noon New York time, a bit of news came out of Europe. As I mentioned in my post of yesterday when Silvio Berlusconi gave a speech Wednesday night he announced no new policy measures. Then the markets crashed. After the bell in Europe Friday, Italy reversed this policy. The Wall Street Journal reported that Italy and the ECB were in negotiations the result of which was that the Italians would agree to a broader package of reform and to speed up their fiscal consolidation. In return the ECB might add Italy to its bond buying program. As mentioned, one of the things that Trichet had left out of his comments on Thursday was any indication that the ECB would intervene in the Italian Bond markets. Now it seems as though the ECB may help break the speculative attack on Italy and Berlusconi will use his parliamentary majority to push through reforms that would go a long way toward cleaning up the fiscal issues that enabled the attack in the first place. Among these, no doubt to the delight of the Tea Party, was a balanced budget amendment to the Italian constitution.

As an aside, I wrote a post a year ago about how I would thwart the speculative attacks in Europe, and a helpful primer on the role of CDS in launching speculative attacks if you are interested.

The markets loved this news and rallied stocks from 1168 to 1210 in about 45 minutes, the markets went straight up the whole time. Once they had gotten back to roughly flat on the day however the markets could not make any additional headway. They bounced up and down around the closing level of yesterday to finish just about where they left off yesterday with the S&P 500 at 1200. All in all it was a truly amazing day, it's not very often that you have the S&P 500 move up and down 5% in a day to close unchanged. So what does it all mean?

Well, I think it means a lot of things. For one thing it means that there is a HUGE amount of uncertainty in the markets right now. A few years ago the S&P would move 6% in a year, now its moving that in a day, day after day. To be fair there are a lot of things which the markets should be concerned about. If the world economy tips back into recession, the debt laden Western countries will struggle to use fiscal stimulus to attempt to jump start the economy. Exogenous shocks and previous monetary easing have raised inflation expectations to the point where further monetary stimulus is not likely to be forthcoming. Despite all the kings horses and all the kings men trying to put the European fiscal balance back together there remains a very real possibility of a successful speculative attack on the Eurozone which would then be transmitted into the European banking system, from the European banking system into the real European economy, and from there to the rest of the world. Such a disaster would be on a scale no one has seen before so no one really knows what to expect.

So what should you expect? Here's what I think will play out. I think the speculative attack on Italy will fail, I think the new package for Greece will hold so I do not think the Eurozone armageddon event will occur. The trouble is that the markets will take quite a lot of convincing and its not the kind of thing that can happen over night. Italy can default in a day, it cannot prove that it will never default in a day, it has to do that by not defaulting over a long enough period of time that people get used to the idea that it will not default. Another complicated aspect of this is that there are likely to be a lot of fractious arguments among the European governments about how to move forward, as with the debt ceiling debate in the US, these arguments have the capacity to unsettle the markets. So I would expect the European concerns to gradually fade out over time but punctuated with episodes of panic like the one we have had this week.

I think the US economy will get stronger in the second half and but I think the markets will respond unusually to the news as it comes out. The only thing the markets love more than real growth in the economy is a sign that the Fed may embark on another round of Quantitive Easing. So you might see markets paradoxically rally on news that the economy is weak, and more specifically, that inflation is in check in the expectation that this will encourage the Fed to print more money and thus raise all asset prices. I think it is also possible that, now that Congress has some time to work, that there might actually be meaningful progress on the fiscal front here in the US. I don't think that is the most likely outcome but I think they'll be talking with the rating agencies about what the minimum they need to do to keep the AAA rating and they'll do that. If the ratings agencies confirm the US AAA then it should be off to the races for risk assets again. If not, look out below.

Look! In the sky, it's a flaming risk asset about to crash into the SS Europa: An analysis of todays market action

2011-08-04T14:40:00.001-07:00

I'm going to take a day off of my explanation as to why the Progressives are just as wrong about the fundamentals of public finance to talk about what went on in the markets today. First, what went on:

First of all, what happened?

1.) Global equity markets fell very sharply. The US benchmark the S&P 500 fell 60 points or about 4.7%, that is a HUGE move. The stock market is now back where it was in early December of 2010. The stock market is now down about 12% from its highs for the year, it has dropped about 140 points or ten percent since July, 25th, this is a big big move.
2.) Money poured into the US Treasury market as it has since the debt deal passed. This pushed the yield on the ten year bond down to 2.42%, this is VERY low by historical standards.
3.) Money poured into, and then out of gold. On the open gold was up about $30 and then during the day dropped $40 to close lower.
4.) The Euro fell sharply against the dollar losing 1.5% of its value in a single day. This is a big move and it is also a continuation and acceleration of an ongoing trend
5.) Crude oil also fell out of bed. Brent Crude dropped 5% to $107.58 a barrel. (I prefer Brent as a measure because West Texas Intermediate largely reflects the dynamics of storage in Cushing Oklahoma but WTI was down 5% as well.)

Why did this all happen?

This is a good question first I will list the news items that have come out in the last 24 hours and then put them into context.

1.) Silvio Berlusconi gave a speech to parliament last night on the issues surrounding Italian sovereign credit. In the speech he reiterated earlier comments he has made about the soundness of Italian finance, reminded the markets that Italy has passed an austerity budget, and in any case he has a majority in parliament if he needs to do anything else. He blamed the recent financial turmoil in Italian markets on fickle markets and a lack of confidence. He did not announce any new policy measures to attempt to deal with the markets but rather pointed out that the Italian primary deficit is very low and therefore very manageable.
2.) Jean Claude Trichet held a press conference this morning at which he announced that the European Central Bank would continue its two main liquidity measures: a bond buying program, and unlimited lending against solid collateral to the end of the year. The ECB was not expected to announce whether or not it would extend these measures, originally put in place during the Greek fiasco in May of 2010, until September. He came out early with the announcement early in order to assure the markets that there would be ample liquidity for the banking system. He also made a number of hawkish comments about inflation.
3.) Spain held a bond auction. The auction went will with twice as many bids as there were bonds for sale but the rate the Spanish had to pay was 80 basis points (0.80%) higher than they had to pay at a similar auction in June, highlighting the stresses on the market for Spanish government paper.
4.) US weekly first time jobless claims came out at 400,000 a little less than expected but still a significantly high number.

First I need to put these events in context. Six weeks or so ago the EU put together a new rescue package for Greece to supplement the one agreed a year ago. The negotiations over this were tense but they were finally resolved. All seemed quite until a few Fridays ago there was a run on the stocks of the Italian banking sector, that is to say a lot of people came in and started selling short Italian banks. It was, and is, widely perceived that this is a speculative attack on Italy. It is actually not easy to borrow and short sell Italian bonds and the CDS market in them is thin. A large proportion of the assets of Italian banks are claims on the Italian government is bonds. Therefore you can get short the Italian government by shorting the banks and this is what has been going on.

There are a few interesting things about Italy. One is that it does indeed have the second highest (after Greece) debt to GDP ratio in Europe. It also has one of the most anemic economies in Europe, with almost no real growth in the ten years preceding the 2008 financial crisis and not a great record since then. On the other hand the Italian primary deficit is only about 4.6% of GDP or about a third of ours. Also Berlusconi, love him or hate him, does indeed have a parliamentary majority, unlike the Socialists in Greece. This means that, if necessary, he can with ease pass additional measures with which to tighten the deficit further. So, if you ask me, Italy is in trouble, but it has plenty of resources with which to defend itself against the speculative attack should it choose to do so. I think Berlusconi was trying to make this point last night and express confidence by not actually announcing any new measure. As you can see, the markets have their doubts.

The reason the speculative attack on Italy is so significant has less to do with the probability that it will succeed than with the consequences if it does. The European Financial Stability Fund (EFSF) that was established to rescue Greece and which has since also assisted Ireland and Portugal is probably ample for the needs of those countries, it may even be large enough to support Spain. Italy has $1.4 trillion of debt outstanding. Not only is it too large to be assisted by the EFSF, it is probably too large to be helped by anyone except the United States and even then it would be touch and go.

What this means is that if a speculative attack on Italy were to succeed in shutting Italy out of international capital markets there is no organization in the world large enough to support it and so it would be forced to restructure. If Italy were to restructure the European banking system would suffer an enormous blow. This is because not only Italian banks but all banks in Europe have substantial holdings of Italian bonds. If they were forced to recognize losses on those bonds it would eat into their capital and shrink their balance sheets along the lines of what happened in the US when the banks had to write down their investments in residential real estate. This would most likely force a major economic contraction in Europe, MAJOR. Even if this is a low probability event the consequences are so dire that many investors are preparing themselves for that possibility. They are doing this by selling risky assets (stocks generally, assets in Europe and therefore the Euro itself) and putting them into extremely safe assets.

During the budget debate a lot of these assets went into gold because there was some concern about whether or not US Treasuries were the optimal asset to be holding. Once the deal was done money has been flowing into treasuries hand over first. US treasuries have gained about 10% this week, that is also a HUGE move. This is a good thing for the US government because it lowers the cost of funding the deficit but it is not good news for the economy as a whole. This is because the spread between the two year and the ten year US Treasury yield is a good predictor of the financial performance of the financial sector. What is the business banks are in? They take in deposits and they make loans. Deposits are usually short term and loans are long term, so the difference between short term rates and long term rates is the primary driver of banking profitability. The government has been trying to help the banks recover from the housing crisis by keeping short term interest rate VERY low and leaving longer term rates relatively high. When every frightened investor in the world panics and pours their money into long term US Treasury securities like they are now the spread between the short term and long term interest rates narrows and reduces the profitability of the banking system. Lower profits in the banking system mean a longer time to recover from the 2008 recession and thus generally less credit available to the “real” economy.

The real economy in the US is also a point of major concern. Todays jobless claims number was sort of ho-hum, no reason to sell off the market 5% but there have been other problems lately. Last Friday the Q2 GDP number was released. The markets expected the economy to grow at 1.9%, not a great number but respectable. Instead the number came out at 1.3% and worse the Q1 number was revised down from 1.9% to 0.4%. These are truly terrible numbers for the real economy, in order to recover employment from the 2008 fiasco we need to be growing much faster. Those numbers were bad but the ISM manufacturing number on Monday was worse as it came out much worse than expected and showed that the manufacturing sector, the sector which has been leading the recovery as banking and real estate have been on the ropes, is just creeping along.

The uncertainty about the real economy is compounded by uncertainty as to what the policy responses will be. It seems from the data that the fiscal stimulus has been a failure. Whether you agree with Paul Krugman that it should have been larger or with me that it was doomed to failure because rational expectations of higher future taxes to fund the borrowing required deter the kinds of investments which would grow the economy, the data are pretty clear. What's more, even after the hand wringing in Washington about how to trim the deficit, the ratings agencies, and through them the markets, think the US is so deep in debt and has such crushing future obligations that it may not deserve its AAA rating. This, and the fact that there is a significant group in Congress opposed to all spending increases means that there is unlikely to be a second round of fiscal stimulus.

Then there is the question of quantitative easing. In both of his press conferences Bernanke has gone to great lengths to show that, as long as inflation expectations remain elevated, he does not have room for a third round of quantitative easing. This is bad news for the markets because they LOVE quantitative easing. QE2 took the S&P 500 up 30% between July 2010 and February this year. The Fed has said it is willing to engage in QE3 but the bar will be set high. That is, in order for them to intervene the economy needs to be slowing significantly, (which it may be but we won't know for sure for a while) and inflation expectations need to be low (which, right now, they are not.)

To this soup I would add the issues that the potential downgrades of US sovereign debt bring to the financial systems. As I have mentioned in a previous post, the global financial markets have been using the US Treasury as a proxy for the risk free rate. If in fact there are significant risks that the US defaults, every other asset in the world should be yielding more than it is given the risk it implies. As this sinks in it may well force a general shake up and reshuffling of the worlds asset allocations and it is possible that the first stage of this would be a global flight from risk which would look a lot like what we are seeing.

So here is what the markets are looking at: a potential fiasco in Europe, a slowing US economy (which will begin to shrink for certain if there is a financial crisis in Europe,) no fiscal stimulus, and very likely no monetary stimulus as well as serious questions about whether or not they are getting paid to take the risks they are taking in all financial assets. This is an environment in which many people would prefer to run home and hide under their beds which is what happened today. Add to this that the US unemployment figures come out tomorrow and there was no reason to go home long anything so there was not even a buy the dip rally at the end of the day, we closed on our lows.

What to expect going forward.

Personally I am a bit more optimistic than the markets are. I think that the odds of a successful speculative attack on Italy. I think Europe will muddle through and I think the US economy will not go into a double dip recession. Yes growth is anemic but I think a lot of what you are seeing in the numbers reflects the exogenous shocks of the Tsunami, the Arab spring oil spike, and jitters around the Eurozone. That said, speculative attacks can acquire a momentum all their own and for the time being, they seem to have the upper hand. If we get a disaster of an unemployment number tomorrow we are going to be in for another very rough day.

The Budget Battle is Over: The good news is we're not going bankrupt tomorrow, the bad news is, we're still going bankrupt

2011-08-02T19:14:00.001-07:00

So, today the Senate passed bi-partisan legislation to lift the debt ceiling by $2 trillion or so averting the risk of an instantaneous default. The bill had $1 trillion of discretionary cuts over the next ten years and empowered a panel to suggest an additional $1.6 trillion by year end otherwise severe cuts in other discretionary programs as well as defense would be automatically triggered for 2013. For a total theoretical savings over the next ten years of $2.6 trillion. Woo hoo!

Alas, the markets did allow either side any time for chest pumping about all they have achieved or finger pointing at the nefarious people across the aisle who had made all this “compromise” necessary in the first place. No, the ink was barely dry on the bill and the champagne was barely wet on the tongue before all hell began to break loose in the markets. It began with more negative economic data but really got serious when Fitch and Moodys put the US on negative watch AFTER the bill had passed.

This must be somewhat bewildering to Progressives because they've been told that it was simply the Republican brinkmanship that was the reason for the potential downgrade. As Obama memorably said: “for the first time ever, we could lose our country’s Triple A credit rating. Not because we didn’t have the capacity to pay our bills – we do – but because we didn’t have a Triple A political system to match it.” And now those dastardly ratings agencies are saying just the opposite. That there is no way the US can pay its bills if things continue as they have. This must be frustrating, and I want to help. In recent days I've written some articles attacking the delusions of the Tea Party, notably the idea that US sovereign default is not unprecedented or that such a default would not constitute a major disaster. Well, now I'm going to provide the same public service for those on the left and try to debunk some of the false impressions under which Progressives have been laboring in a series of posts.

Before I do that however I want to take a moment to address some issues of terminology and reference. Throughout the debate when people have described cuts, or deficits or revenues those numbers are aggregated over the next ten years. The deficit they seek to address is that contained in the CBO Baseline Outlook for 2011-2021. This is a trick of terminology to make things sound a lot bigger than they are, $1 trillion in cuts sounds like a lot but it's really just $100 billion a year for ten years and the government is borrowing $1.6 trillion this year alone. If you crack open that report you'll see that under the baseline scenario the government will borrow an additional $9.2 trillion over the next ten years. It is also important to note that the underlying economic assumptions are somewhat optimistic. They assume that the US economy grows 3.1% this year, 2.8% next year, then at 3.4% until 2016 and at 2.4% from 2016 to 2021 this growth is constant with no recessions. Given that the actual data coming out show that the GDP is growing much more slowly in 2011 (1%,) it is likely that many of the revenue estimates will turn out to be on the high side with correspondingly higher deficit numbers.

So, todays common Progressive misperception is:

The main reason we are even in this position is the Bush administration. If we just roll back the Bush Tax Cuts and end the wars in Afghanistan and Iraq the problem is solved.

You may have seen your progressive friends posting these charts from The Atlantic and The New York Times up on the internet which purport to show that the deficit is the result of the policies of the Bush administration. The New York Times chart shows that at the end of the Clinton administration budget surpluses were projected as far as the eye could see until the wicked Bush Administration took over and began deficit spending like there was no tomorrow. Then President Obama takes over having inherited this fiasco he adds merely a trickle to the flood of red ink.

To begin with the NYT chart is internally inconsistent, on one slide Obama is responsible for $187 billion of additional spending, on the next it's over a trillion. Interestingly she forgives Obama's shortfall in revenue due to the recession but does not recall that Bush also came into office in the middle of a recession caused by the collapse of an asset bubble and instead assigns all revenue shortfalls to the pernicious Bush tax cuts. She then makes the argument that by far the largest contributor to the deficit is the Bush Tax cuts and that if they were repealed we're on a trajectory to sustainability. I wonder what the CBO has to say about that, stay with me, friend reader.

In the Atlantic, James Fallows makes more or less the same point. He goes to great lengths to say he's not interested in being partisan and then like the NYT lays all the blame at the foot of the Bush Administration, its wars and its tax cuts. Fallows also projects forward the surpluses of the Clinton era. He also assigns all the responsibility revenue shortfall to the tax cuts rather than the combination of tax cuts and decreased tax revenue during the 2001-2002 recession. Obama can claim a weak economy Bush, no dice. I do however appreciate Fallows' citation as “an analysis based on CBO data.” Rather than use the CBO data directly he manipulates it to make his point reclassing some of the revenue shortfall as tax reductions in order to magnify the effect of the tax cuts for Bush while he magnifies the effect of the recession for Obama. (Of course there is also this chart which is totally nonsensical, he has the Obama stimulus package ending in 2013 but the recession goes on to 2019, not to mention the wars.)

I only wish that these estimable journalists had kept at the CBO data coalface once they were done assigning the blame for the current predicament to the Bush administration. The CBO is a veritable cornucopia of interesting data including projections as to what the deficit will be. In fact, as mentioned these are the very projections referred to by both sides throughout the debate. Let's just have a closer look in here... wait what's this? The CBO projects revenues to go from $2.228 trillion in 2011 to $3.442 trillion in 2014? How can that be, an increase of 55%? GDP is only growing at 3% during that time, where is all that revenue coming from? Oh, wait a minute, the CBO baseline INCLUDES ALL CURRENT LEGISLATION. Thus it assumes the Bush tax cuts expire, and for that matter, the Wars in Iraq and Afghanistan end on schedule. But wait a minute, even with the expiration of the Bush tax cuts and the end of the wars the government still winds up $9 trillion deeper in debt at the end of it?

Yes it does. As it turns out, the press has done a disservice to the debate by attempting to show that the Bush tax cuts are responsible for the deficit problems that the Tea Party Republicans are trying to solve. The Bush administration is guilty of a great many fiscal sins, and doubtless the current debt would be lower had be been more fiscally conservative, but even after all his policies are withdrawn we still have to borrow $9.2 trillion over the next ten years to fund the government. Sorry Progressives, the problem is in the future, not the past, and because we are reluctant to face it, we are being punished by the rating agencies.

Tomorrow: The Keynesian Endpoint

Imaging Armageddon: What Will Happen if the US Defaults?

2011-07-27T15:02:00.001-07:00

"Those whose duty it was to watch over the safety of the country lived simultaneously in two different worlds of thought. There was the actual visible world with its peaceful activities and cosmopolitan aims; and there was a hypothetical world, a world 'beneath the threshold,' as it were, a world at one moment utterly fantastic, at the next seeming about to leap into reality-- a world of monstrous shadows moving in convulsive combinations through vistas of fathomless catastrophe." -Winston Churchill, "The World Crisis; Volume I, 1911-1914"

I saw a poll yesterday which indicated that Americans are roughly evenly split on whether or not a US sovereign default would be a major catastrophe. This is pretty shocking to me because it seems transparently obvious that this would be a major catastrophe for which most of the world is vastly unprepared. So here is a litany of events that will cascade if and when the US halts payments to creditors.

1.) America will be shut out of the international capital markets for some period of time. If you are known to willingly default, then people stop lending you money.

2.) An instant MASSIVE recession. Though many people have a vague idea that the deficit is large they do not quite fully understand the degree to which the government services they enjoy are debt financed or just how large a fraction of the economy those services have become. Hmm... I wonder how big that is... lets have a look at it on the official budget document (check supplemental table S-1 on page 171) So here are the facts: in 2011 the government will take in $2.174 trillion and spend $3.819 trillion leaving a deficit of $1.645 trillion. That is to say that this year of the services the government is providing, it is borrowing 43% of it or for every dollar the government took in taxes, it borrowed another 75 cents and then spent it. Another way to think of it is that this deficit is about 10% of GDP which is to say that one out of every ten dollars in the economy this year was funded by federal borrowing. Does that sound like a lot? It sure as hell is. This is why the Tea Party is so freaked out, we really are in a deep hole. Is this the right way out? Probably not. Because once we default all that borrowing will come to a screeching halt and we will have a contraction in the economy of roughy 10% of GDP at high speed.

For some perspective on this remember the “great recession” of 2007-2009? During that time the economy shrank by about 12%. Now imagine a similar level of economic chaos happening IN A DAY. That's what we're looking at.

3.) Holders of US Treasury securities will begin to sell them. The US Treasury market is the largest single asset class in the world. This means that organizations that have to save a large amount of money hold a lot of them. Specifically Central Banks who peg their currencies to the US dollar have MASSIVE holdings of Treasuries. They also have a mandate to not lose money another reason they have been in Treasuries, until now they have been thought of as virtually risk free. Once the US chooses to default those holders will be tempted to begin to liquidate their holdings. It won't be an easy decision because even after the US Treasury begins to default the value of these bonds will not go to zero. This is because everyone knows that the US will at some point want to try to borrow money again. In order to do that they are going to have to have some kind of settlement with the holders of the pre-default bonds for some nominal amount of money. The large holders of the bonds will, if they can statutorily, hold on to the bonds because they'll have a lot of negotiating power with the US government. The problem is, as people sell them, the large holders will have to take larger and larger losses and may decide themselves to sell. One particular problem they will face is that almost immediately they will have to take large losses because a trick of the CDS settlement process.

4.) CDS are “Credit Default Swaps.” These are basically debt insurance policies and just as you can buy them to insure the risks you have of a company defaulting you can do the same for a sovereign. Let's say I sell you a $1 million CDS on IBM and then IBM goes bankrupt. I'll have to pay you the difference between what he lenders are able to recover of their original loans through liquidating the assets of IBM and the $1 million. So lets say that after selling all the real estate and type writers the creditors get 20 cents on the dollar, I owe you $800,000.

So, when an issuer on which a CDS has been written defaults there is a mechanized process by which all the people who owe insurance payments pay all those who are owed payments. At the center of this process is a large auction. This is because it takes too long to figure out how much money is going to be recovered in a liquidation. So what ISDA, the group responsible for settling CDS does is it hosts a massive bond auction to arrive at the markets best guess as to what the recovery value should be and then uses that price to benchmark who owes what to whom.

Historically this has not been the case in a sovereign default. What would happen is that the large holders would hold on and try to negotiate the best terms possible from the defaulting government. This happened in Russia in 1998 and again in Argentina in 2001 the bonds might trade but thinly and most effort was focused on the negotiations. But now, ISDA arranges a massive auction which would force all holders of US Treasuries to instantly realize their losses. Remember also that at the same time as this auction is being held the Peoples Bank of China and the Saudi Arabian monetary authority are going to have to decide whether or not to sell their holdings. And then here is ISDA hosting a nice auction, or liquidity event for them. Needless to say this could get ugly. It is hard to imagine a world in which there is a US sovereign default, then an auction with mildly well capitalized vulture funds on the buy side and the largest central banks on the other. Something tells me prices will go down, a lot. When the PBOC et all blow out of their treasuries they'll probably be blowing out of their dollars as well. So we would have a simultaneous dollar crash and interest rate spike. This would be, shall we say, manifestly not helpful for coming out of a 10% recession.

5.) The most interesting aspect of this for me is that it would basically destroy the modern framework of theoretical finance. In the way that the law of gravitation is central to the modern understanding of physics, the Capital Asset Pricing Model or CAPM is central to an understanding of modern finance. Basically the CAPM says that all asset in the world are related to each other through their expected rates of return and the variance, or risk, associated with that return. The idea is that returns and risk should be positively correlated, that is to say the more risky something is the higher the return. This is enforced by the daily actions of markets. If I have two assets which have the same return but one is more risky than the other I'll sell the risky one and buy more of the less risky one. This action will push down the price of the risky asset and thus increase its return. I'll stop doing this once the return is high enough for me to be willing to take on that risk.

6.) In this way all assets are related to all others and all of this assumes that, at the base of it, there is a risk free rate. That is a rate of return on which there is zero variance. Once you have that rate you know a great deal more about the relative attractiveness of all the assets with non-zero variance. For the entire existence of the theory the markets have used the US Treasury rate as a proxy for that anchor risk free rate and have priced all, and I mean ALL, other risk assets at a spread to that risk free rate. This made sense because after all the United States has hundreds of years of continuous Constitutional Governance, is surrounded by oceans or nations it dominates militarily, has thousands of nuclear weapons and has legal taxing power over the most productive economy in the history of the world. Sounds pretty risk free to me, except for one small thing. It can CHOOSE to default. If it does it would be the financial equivalent of altering the gravitational constant. The theory which links all asset classes to one another will have had its bedrock assumption thrown out the window and will have to reconstitute itself.

That process will begin with sudden massive repricing of all the risk assets in the world as people realize that the world is actually much more dangerous than they had been thinking for the preceding fifty years or so. This will start slowly and will build at huge speed in parallel with the CDS auction/fire of Treasuries which will jack interest rates in the US to the moon, the collapse of the dollar which will jack commodity prices to the moon, and simultaneous with the 10% of GDP recession induced by the sudden withdrawal of US government spending.

It is, in short, the end of the world.

A close analysis of Ron Paul's Bloomberg Op-Ed

2011-07-26T22:59:00.000-07:00

In order to see into the mind of the men who are behind the brinksmanship over the debt ceiling it is instructive to read the editorial that Ron Paul wrote to on Bloomberg on Thursday. Ron Paul is a Republican and a libertarian who is a presidential candidate so his views are important. Among his more controversial views are the ideas that both heroin and prostitution should be legal. Whether you agree with these views or not I think they are consistent with his views of the effects of the consequences of a breach of the debt ceiling: that is to say they begin with a deceptively simple premise but struggle under close analysis.

Ron Paul is one of the leading conservatives pressing for a voluntary default through a Congressional refusal to rasie the statutory debt limit. His overall view is that such a default would be painful but not catastrophic and would, in the long term, be healthy because by withdrawing access to capital markets the government would be forced to live within its means. He would prefer this to happen sooner rather than later. It seems to me from his editorial that his views are based on a false analogy, a clear lack of understanding of the mechanics of a fiat monetary system, the role of the Central Bank, and the degree to which a default would resolve our problems by becoming some kind of deus ex machina which would instill the discipline that he and his colleagues, and ultimately we the voters, have so far been unable to muster.

Paul begins his editorial by claiming that default by the US government is a common occurrence and each time it has not been followed by a major calamity. The three examples he mentions are as follows: first when Roosevelt revalued the dollar against gold and forbade transactions in gold in 1934. The second is when congress stopped silver redemption of the dollar in 1968, and the last was the “Nixon Shock” when Nixon halted gold the convertibility of dollars into gold at the rate fixed via the Bretton Woods Accords. As should be obvious to anyone with an economics background, none of these events constituted a formal default. They were all currency devaluations. They were steps on the road from a monetary system tied to gold to a “fiat” system, one in which the values of currencies were determined by the “faith” of markets.

From the post Civil War resumption of payments in gold in 1871 until the end of the Bretton Woods international monetary system in 1972 the US dollar was convertible into gold or silver at a fixed ratio though that ratio was periodically subject to change. In the early 1930s after the stock market crash precipitated the systemic collapse of the US banking system America entered a deflationary spiral. Because the dollar was pegged to gold the Federal Reserve lacked the tools that Ben Bernanke has used to prevent a similar deflationary spiral in the aftermath of the real-estate/Lehman collapse. Changing the rate at which the dollar was convertible into gold was a primitive form of "quantitative easing" it basically created more dollars relative to gold.

After the second world war, in order to help the rebuild the economies of the anti-Soviet alliance we had assembled we established a global fixed exchange rate regime called the Bretton Woods Accords. This was a system of fixed exchange rates and capital controls. Bretton Woods effectively pegged the currencies of every country in the world to the dollar and pegged the dollar to gold. At the time the US was 45% of global GDP and the largest trading partner of every major industrial country, as a result at the start of the system it was a trivial matter for the US to function as the anchor. By the late 1960s the rest of the world had recovered, the global trading system as I have outlined in another post had recovered and advanced to levels never before seen. The Bretton Woods arrangements which had originally served to buttress the global free trading system began to hobble it, particularly its anchor, the United States. America had been fighting the Vietnam War and had embarked on a series of costly social programs which resulted in high levels of money creation which made the maintenance of the gold peg extremely difficult. Gold and silver began to pour out of the country. In 1968 the government stopped redeeming dollars in silver at a fixed rate. It threatened but did not destroy the Bretton Woods System because that was pegged to gold. Then in 1971 Nixon fully halted gold convertibility of the dollar which set the stage for the dissolution of the global regime of capital controls and fixed exchange rates. This in turn paved the way for the global fiat monetary system we have today. Keep in mind that though the government no longer pegged the dollar to gold, the whole time if continued to borrow, and repay, all its lenders in US dollars which were legal tender for all debts public and private in the United States.

So as you can see, all these episodes are the systematic detachment of the US dollar from the gold standard and are therefore devaluations. Ron Paul conflates them defaults. From a narrow perspective this is true. Let's say for the sake of argument that you were a hedge fund founded the year of the American Centennial in 1876. Let's further imagine that your strategy was that you would borrow gold, take that gold change it into dollars and then lend it to the US government thinking to yourself that, since the dollar was convertible into gold if anything went wrong you would simply sell your Treasuries, change your dollars for gold at the fixed rate and then pay back whoever had lent you the gold. If you had that strategy on in 1934, 1968, or 1971 you may well agree with Ron Paul that the US government had defaulted on you. After all, they were paying you back in dollars but those dollars were worth far less in gold terms than they had been when you originally borrowed the gold. You got smoked.

The question to ask, however, is how many people were in that position and did it damage the credibility of the Federal Government? Well, considering that the financial power of the age, Great Britain, had abandoned the gold standard in 1931 there was virtually no one in that position and given that in Bretton Woods all the worlds currencies were pegged to the dollar which was then pegged to gold, literally no US Treasury investor on Earth was in a position to be harmed by the US abandoning the gold standard. Yes, it was a devaluation of the dollar in gold terms and so if you were a holder of US Treasuries benchmarked to gold you would consider the US to have defaulted. But, since 1945 the dollar itself has been the reserve currency of the world it is pretty hard to think of the abandonment of the gold standard as a default. It was not accompanied by a reduction in the credit rating of the US or even of a mild disruption of the American ability to access global capital markets. Ron Paul's problem is that he looks at these devaluations and conflates them with default. He then draws the conclusion that since these defaults were not do bad that a straight up default would not be so bad either. Of course, as you can see, from start to finish these were not defaults and therefore Paul's logic is deeply, deeply flawed and massively underestimates the chaos which would result in a straight up de jure default on US Government obligations.

In his next two sections entitled “Unlimited Spending” and “Boom and Bust.” In them he makes the claim that once the US was off the gold standard it was free to borrow as much as it liked limited only by demand for Treasuries. He also concludes that the Federal Reserve is responsible for the business cycle through its control of interest rates. These assertions also have a tenuous connection at best to the historical record.

First of all, as we can see in the European periphery, there is indeed a point at which, even in a fiat monetary system, the bondholders will pull the plug on a sovereign borrower. Thus a fiat monetary system is not the blank check he claims. While it is true that the capacity of the US government to borrow is limited only by the willingness of investors to buy treasuries the US had a far far higher debt to GDP ratio in 1946 when we were still on the gold standard. For that matter the highest debt to GDP ratio in the history of the world that did not result in default (Great Britain, 1814, 225% of GDP) also occurred under a gold standard. So fiat money did not create the capacity for governments to borrow titanic sums. As far as speculative bubbles being the creation of central banks he might want to look over the history of the Dutch tulipomania which occurred in the absence of a central bank or the panics of 1857, 1869, 1873, 1893, or 1907 all of which occurred before the Federal Reserve Act to see that this is quite simply not the case.

Then comes his section on “Hard Decisons” and here the mistake Paul makes is a simple one of accounting, though it spectacular consequences. “It isn't too late to return to fiscal sanity,” he says, “we could start by canceling out the debt held by the Federal Reserve, which would clear $1.6 trillion under the debt ceiling.” This is simply ludicrous. Something to remember about The Federal Reserve Bank is that it is, as the name implies, a bank. This means it has a balance sheet. On one side of that balance sheet are the assets of the bank, among them $1.6 trillion in US Treasury securities, ordinarily considered risk free. Also on that side are another $1.3 trillion of other assets for total assets of $2.9 trillion. On the liability side there are $2.8 trillion in liabilities including $1.6 trillion worth of deposits from the nations commercial banks which they are required to hold at the Fed in order to ensure their safety and soundness and a mere $25 billion in equity. So guess that happens if you force the fed to write down $1.6 trillion in US Treasury securities because you have “cancelled them out.” You create a $1.6 trillion hole in the Fed's balance sheet which would, in effect, make the Federal Reserve Bank insolvent. THus it would be unable to redeem the $1.6 trillion in deposits back to the banking system and therefore transmit that insolvency to the entire banking system and from there to the real economy. This, of course, would be a major economic fiasco. Thus either the Fed would have to print $1.6 trillion, which I am sure Ron Paul does not envision with this plan, or the government would be forced to recapitalize the Fed to the tune of $1.6 trillion. Does the government have $1.6 trillion? No. It would have to borrow it, and we're right back where we started. I find it somewhat shocking that A.) Bloomberg printed this, and B.) there are people who think of it as a realistic possibility.

So Pauls theory is essentially that we have defaulted a lot in the past, that these defaults were not fatal, and that if we default today it will, in the short term, limit the access of the government to credit markets and therefore force the government to live within its means. Therefore, he concludes, default is the best option. This is of course absolutely insane, a straight up de jure default by the US would not only shut the US out international capital markets, but it would also obliterate the global fiat monetary system as well as force a massive repricing lower of every risk asset on Earth. Think of it in these terms, the post Lehman recession was two consecutive quarters of -6% GDP growth. The deficit is currently 12% of GDP, so a default which shut the US out of capital markets would be the equivalent of having all the financial turmoil for the fourth quarter of 2008 and the first quarter of 2009... in a day.

The other half of the problem with Ron Paul, is that though he is entirely wrong with his prescription for what ails the US, he is not wrong about the diagnosis. It is true that the net liabilities of US government entities at all levels are in the hundreds of trillions. It is true that no amount of “taxing the rich” will come close to financing them. It is true that the most likely outcome is serial inflations and defaults. Because these things are true he seems to have some credibility, indeed he is one of the few in Congress who grasp just how deep the problem is. Unfortunately, he is like Karl Marx, he has correctly identified the problem but his solution is destined to failure and catastrophe. He intends to rely on the bondholders to instill the discipline that he and his colleagues do not possess. But this is why we elect people like Paul to serve us in Washington. The right thing to do is to have the voters decide how much pain gets taken, by whom and at what speed. People like Ron Paul who would prefer to throw their hands in the air, and let the panicking bondholders decide those things are abdicating the very responsibility they have been granted by their constituents.

It is a crime against the country and the Constitutional order they feign to revere.

Nothing to Smile about in DC.

2011-07-25T21:43:00.000-07:00

So the circus in Washington has made me decide to restart my blog.

So I've been following the debt ceiling talks very closely and I have just finished reading the transcripts of the television addresses of Obama and Boehner.

Where we are is this: the Democrats and the Republicans are miles apart and are not even negotiating. Instead they are trading barbs on twitter and blaming each other on national television. From the legislative perspective each party is crafting a separate bill in the chamber in which it has a majority and attempt to brute force it through the other chamber. This is very much a non-trivial matter. The Republicans might filibuster the Democratic bill in the Senate which would mean that they can't even get it to the House. This would give the GOP the advantage in that their bill might be the only game in town which would put additional pressure on the Senate and Obama to pass it. In my opinion, the bills are substantially different and are both primarily motivated by the political interests of their authors and are an attempt to frame the opposite party as unreasonable rather than to try to compromise.

The House bill recognizes the failure of the GOP to make progress on trimming the deficit and seeks to buy more time. Their bill contains a $1 trillion increase in the debt ceiling matched with the $1 trillion in spending cuts that were the least controversial in the recently failed negotiations. This is paired with a requirement to appoint a commission which will be tasked with finding another $1.6 trillion in cuts to both discretionary and entitlement programs as well as revenue increases through reform of the tax code. Only once the additional $1.6 spending cuts have been identified will the government raise the debt ceiling an additional $1.6 trillion. Some kind of deal would have to be reached relatively shortly because the government will blow through the $1 trillion borrowing limit in less than a year.

The plan of the Democratic Senators is to raise the debt ceiling by a full $2.6 trillion by pairing it with $2.6 trillion in spending cuts and no revenue increases. The Reid plan draws all of the $2.6 in spending reductions from discretionary programs and does not envision any changes to Social Security and Medicare. Of the $2.6 trillion $1 trillion is from the wind down of the wars in Afghanistan and Iraq and $400 billion is from “interest savings” though it is not at all clear to me how it possible for the government to save $400 billion by altering the term structure and interest rate profile of the debt especially considering that interest rates are pretty close to their theoretical minimum today and, given inflation, you could argue that they are in fact negative. Thus interest expense has nowhere to go but up. I don't think this really bothered the Reid staffers who put it together because they were primarily interested in getting to the $2.6 trillion number as fast as they can.

Both of these plans are ingeniously designed to make the other party look as though it is reneging on its original commitment. The Republican plan is actually the policy that Obama partially implemented earlier in the year when he appointed a commission to study the deficit. The trouble with that was that Obama then dissolved the commission without implementing any of its suggestions, or proposing any deficit reduction legislation whatsoever. Instead he left it to the House Republicans, a decision he almost certainly regrets. The Republicans will claim that they are just implementing Obama's original policy but with a hard deadline connected to the debt ceiling. The Democratic plan optically looks like what the Republicans asked for originally: $2.6 trillion in spending cuts with no revenue increases. Of course $1 trillion of those cuts come from reductions in defense expenditures which are already not projected to occur and $400 billion is in interest savings which will, as a practical matter be virtually impossible to capture. So the headline number of $2.6 trillion contains $1.4 trillion is in cuts that are not really cuts so in terms of actual effect its much closer to the current $1 trillion plan the GOP has put forward.

So basically both parties are offering to trim around $1 trillion in spending over ten years. The main difference is the timing of the next debt ceiling increase, the Republicans want it before the next election and the Democrats want it after the next election. It is pretty simple to understand why. Many of the Republican Congressmen elected in 2010 were given a mandate to cut spending. If they want to win reelection in 2012 they need to show that they have done this. It is obvious that the current impasse will not produce meaningful spending cuts so they need another chance to produce an agreement before the 2012 elections. The Democrats of course do not want this to become a major issue during the presidential election because what will be happening then is that Obama will not only be squaring off against the Republicans in Congress but also against Republican Presidential candidates who will all have strong opinions on what should be done with the debt ceiling but with no responsibility for actually doing anything. This would weaken him both as a candidate and as a negotiator, a position he will certainly seek to avoid.

So this is where we find ourselves with less around a week to go until the deficit ceiling needs to be raised. Two parties framing legislation designed to favor them in 2012 and, in the event that they fail to pass the legislation they each have the ability to claim that the other side reneged on its original strategy for narrowing the deficit. Meanwhile the government continues to borrow $3.8 billion dollars a day and the debt ceiling approaches.

I am the Great Barazi! Dr. Omar.... you are getting sleepy.... very sleepy... I'm now going to snap my fingers and when I do, you will pay me.

2010-09-08T15:20:00.001-07:00

So I know I’m kind of a block behind the parade on this but I just got done reading the latest broadside from the good ship DIFIC against the HMS Barazi off the coast of Dubai. It seems like fairly weak soup to me. Most of the DIFCI response is taken up with a lengthy chronology of the various memos that went back and forth between the various members of the DIFCI management team and tries to clear up who knew what when. In my last post I ignored this but now I have paid much closer attention. This is a little more complicated than I would like because the court makes the letter from DIFCI public but not the attached exhibits so it is not possible to follow the evidence trail directly. Having read it now I think my initial instinct to disregard it was correct.

DIFCI goes through the lengthy chronology in order to show that in the first two drafts of the investment bonus memo he makes reference to a net income of $200 million. Between the first and second drafts Bisher was sent the unaudited financials which showed that the net income was a loss of $87 million and the second draft was not amended to reflect that. This is the core of their argument that Barazi misrepresented the financial condition of DIFCI. They go on to claim that Barazi knew all along that the DIFCI was in serious financial shape and provide an email he sent to that effect.

This doesn’t make a lot of sense to me. At no point in any of the memos does Bisher suggest paying out bonuses on net income. Instead he suggests paying out bonuses based on realized gains. Considering the business that DIFCI was in this makes some sense. They were running an investment fund containing investments which were highly illiquid either because they were in private companies or else such massive stakes in public companies that they could not be disposed of. To pay yourself based on the performance of a investments that you may not actually be able to monetize might not be best. So I can see the reasoning behind paying themselves based on realized gains rather than net income.

The net income reference was made for the purpose of comparison with the realized gains and was made before the unaudited financials were available. It is true that the second draft was not amended to take into account the new information in a subsequent draft all reference to net income was dropped. Note that this would not have affected the thrust of the memos because they were being paid on realized gains. The relevance of the loss of $80 million has to be taken in context. This is on a multi-billion dollar investment portfolio and the loss was the result of an accounting change. While I think it had some relevance I think it would make as much sense to pay them zero based on the $80 million as it would to pay them $30 million on the $200 million. In any case they were paid on the realized gains of $60 million, a figure which is not disputed at all by the DIFCI. Also at no point did Bisher seek to conceal the $80 million loss, the DIFCI makes a point of saying he signed off on those numbers. Had he attempted to conceal that and paid himself on the basis of false returns that really would have been fraud but DIFCI does not allege this because it did not occur.

As to the allegation that Barazi knew the DIFCI was in hot water at the time of the bonus the evidence they provide is pretty slim. They show an email pleading for additional funds from mid-November 2008. The final memo on the 2007 bonus issue was in July of that year and the most relevant documents were finished by April. Of course everyone knows what happened in September of 2008, Lehman brothers defaulted and the markets went over a cliff. To say that the financial position of the DIFCI post-Lehman should have influenced the 2007 compensation decisions which were made in March seems to me be kind of a stretch. Something may well have been amiss in the finances of the DIFC in the spring of 2008 but the DIFCI response does not show it.

The DIFCI leads their response by denying that “the claimant can not absolve himself from the liabilities arising out of his conduct with respect to the procurement of the 2007 investment bonus on the basis that Dr. Omar authorized that bonus.” It then quotes the handbook saying that management cannot be indemnified against moral turpitude or other misconduct. In the following paragraph they say that “Barazi was not a passive recipient of the bonus” and point out that he played an active role in determining it. This is the weakest part of the case and also the most central.

It is true that Barazi was not a passive participant. This is because, as the DIFCI points out, there was no established methodology for compensating the managers of DIFCI for their performance. Barazi was asked by Dr. Omar to come up with one. They allege that his methodology constitutes moral turpitude and therefore a fraudulent attempt to compensate himself. As mentioned above the centrepiece of this argument is that a change in net income was not reflected in the memo until its third version. I argue that this is not relevant for two reasons. First the net income played no role in the calculation of the bonus and therefore failing to change the memo to reflect the change in net income until the third version does not constitute moral turpitude as the change would have had no effect on the calculation. Also the $87 million loss was never concealed from anyone including Dr. Omar.

Far and away the most important reason that it doesn’t matter is the point they themselves make that the DIFCI “lacked a clear cut methodology.” What that really means when combined with the fact that compensation was “at the sole discretion of the chairman” is that Dr. Omar did not need to refer to anything but his own fancy in order to compensate himself and Barazi. He could have rocked out of bed one day, walked into the office and said “Bisher, that’s a great haircut. I’m going to pay you $10 million.” Or “That was some fine singing at karaoke last night Bisher, here’s $5 million.” Heck, we should be happy that they made any effort to come up with a plausible methodology at all.

The DIFCI ties itself in a pretzel when it argues that Bisher established a questionable methodology and then further argues that he did not properly follow that methodology which it has already alleged was questionable. The fact of the matter is that because of the way DIFCI and the DIFC were set up there was no requirement for a methodology whatsoever. The mysterious workings of the mind of Dr. Omar were all that were needed to pay them out. As a result the only practical way for Barazi to have fraudulently acquired his bonus would have been for him to put Dr. Omar in a hypnotic trance and fraudulently induce him to write him a check. I wouldn’t put it past Bisher to do that but I think it would be really hard to prove in a DIFC court.

Speaking of Dr. Omar and due process what does the DIFCI say with regard to the unspoken allegation in the previous Barazi response that no legal proceedings were brought against Dr. Omar to compel him to disgorge his bonuses? In paragraph 41 the DIFCI says “the defendant notes that Dr. Omar has returned $13,600,000 in bonuses he received from DIFC.” Interesting, there seems to be no mention of legal proceedings. Presumably this would mean that the proceedings used to get Dr. Omar to disgorge this bonus were extra-legal. There’s another word for that, “extortion.” But I’m sure Barazi is really quite familiar with that term right now. This will indeed be a very interesting case if it goes to trial.

Personally I think the DIFC should drop the suit, pay Barazi him his severance conditional on the completion of the forensic audit. If they have real evidence of actual fraud they should charge him with that, not go back and forth with him over whether or not he is entitled to severance based on whether or not he used a proper methodology when no methodology was required.

There goes the Stimulus Package on it's way to China.... the beginning of the end of the WTO.

2010-09-06T18:35:00.000-07:00

Whenever everybody in the US political sphere agrees on something my instinct is to oppose it simply so there is opposition. The one thing the Bush and Obama administrations have in common (aside from their fondness for massive deficit spending) is their assertion that the maintenance of the global free trade system is essential for American prosperity. One of my favourite mantras from my time at the University of Chicago was: “If someone asserts it, deny it. If someone denies it, assert it.” So, I am going to deny the assertion that free trade is currently the optimal policy for the United States.

First, let’s remember the origin of the free trade system. Its original motivation was political/military rather than economic. The Second World War was a massive human tragedy which killed something like 3 % of the human population in just under ten years. For the American economy, however, this tragedy had a silver or rather gold lining: it was a war of annihilation between America’s main economic competitors. The war destroyed the industrial capacity of the Axis Powers and severely disrupted that of Central Europe and Soviet Russia. At the end of the war the United States was the only power in the world with an unimpaired industrial plant and as a result in 1945 the US accounted for nearly 50% of world GDP.

Despite its economic supremacy, America faced a severe political/military challenge from the Soviet Union. The Red Army had just crushed the Wermacht and was positioned in the Center of Europe and invaded Northern China near the end of the war. Americas grand strategy was to contain the Soviet Union with a ring of alliances that stretched around the periphery of the Russian empire. Unfortunately the allies who composed this ring were the battered former Axis powers and the supine allied European states.

America needed to revive the economies of the Western Alliance if the containment strategy were to succeed so it came up with a global economic plan with several features. The first was a massive influx of aid in the form of the now famous Marshall Plan. The second was the establishment of a stable foreign exchange regime which would simplify trade through the Bretton Woods agreements. Finally was the establishment of a trade liberalization regime under the General Agreement on Tariffs and Trade or GATT which became what we now know as the WTO. The first round held in Geneva in 1947 eliminated or reduced 45,000 tariffs. Subsequent rounds made great strides in bringing down tariff barriers all over the world. While the GATT was a multilateral organization, the fact that America was the only intact market on the planet meant that it’s most salient feature was granting more or less open access to the American consumer for our allies in the struggle against the Soviet Union.

The plan worked like a charm. Between 1948 and 1953 world trade grew by 40%. By 1963 the total volume of world trade was three times what it was before the war and twice its previous all time high. By 1971 it was six times what it had been in 1935. This is an extremely important point, the creation of the GATT system ended the generally mercantilist regime that predated the World Wars and international trade exploded as never before in human history. This channelled massive amounts of wealth to the various trading partners that would not have been possible without it and enabled a rapid recovery from the devastation of the war. By the end of the Cold War in 1989 Germany had the same share of world GDP that it had before the war and Japan had twice as large a share. America and its allies presented an economic, military, and political challenge to the Soviet Union that it could not overcome and it collapsed after a failed coup attempt in 1991. Mission accomplished, well and truly.

After its victory America, confident in its permanent supremacy, kept the global free trade regime open. Indeed it expanded it, bringing in its erstwhile opponents Russia in 1993 and China in 2001. The maintenance of this free trade regime after the end of the cold war has arguably had an even greater effect on the world than it did during the cold war itself. By enabling China and India to access the US consumer on a level playing field the global free trade system has helped to bring 400 million people out of poverty in the last 20 years. This is a reduction of human misery that has been without precedent. It has made the world economy as a whole more efficient and raised world GDP by a substantial amount. The huge American trade deficits have been a massive subsidy to the rest of the world particularly China.

To get a sense of how important this is to China you have to look through the numbers a little. In 2006 the Chinese trade surplus with the US was around $250 billion and Chinese nominal GDP was around $3 trillion (I use nominal rather than PPP because we are talking about international trade rather than domestic consumption.) So the Chinese trade surplus with the US in 2006 was 12% of the entire Chinese economy. This overstates the case somewhat because China has trade deficits with countries which supply it with raw materials but in turn those deficits are driven by and more than financed by the surplus with America. Considering that an additional 40% of the Chinese economy is investment which is largely export oriented the impact of the global free trade regime accounts for nearly half of the Chinese economy. These are just numbers, what this has meant in the quality of life for hundreds of millions of people cannot be overstated or really understood unless you go to China and see if for yourself. It is truly mind boggling.

So how has it been working out for the country at the center of the system? This is a complicated question and it comes with a complicated answer. From the perspective of the American consumer this has been awesome. The global economy is much more efficient and the increasing globalization and the addition of hundreds of millions of new workers to the global trading system has kept down the prices of labor intensive products. In the immediate post-war era Americans got used to consuming at a level commensurate with a country which was producing 50% of the worlds GDP. As America’s share of GDP has declined the American people have been reluctant to reduce their consumption. And they haven’t had to because America’s trading partners have been willing to lend their surpluses back to America in order to finance yet more consumption. Yep, from the perspective of the consumer it seems like a good deal all around.

So how is it working out for the American worker? This is kind of a mixed bag. From the perspective of the American knowledge worker it’s working out quite nicely. People in the intellectual capital intensive businesses can farm out of the labor intensive aspects of their business to China for manufacturing or to India for services where the labor costs are much lower. For unskilled and semi-skilled Americans this has been a disaster. They are now forced to compete with the 400 million other semi-skilled workers in the global trading system and this has been pushing wages down. Here in the future the global market clearing price for a year of work in a factory as a semi-skilled worker is somewhere in the neighbourhood of $8,000 per year. Naturally this is not enough to sustain an American lifestyle which is why, as mentioned above, the American lifestyle is increasingly debt financed.

You can hear the echo of the global free trade system whenever Americans bemoan the problems with the economy. “Wages for working Americans have been stagnant for 20 years;” this is because American workers are competing with another 400 million people that were not in the system 20 years ago. “The divide between the rich and the poor is getting wider,” the rich benefit from lower prices and the ability to tap cheaper foreign labor which increases their earnings, the unskilled now have to compete with that foreign labor which decreases their earnings. “The post housing bubble unemployment seems to be structural not cyclical,” many semi-skilled workers who’s manufacturing jobs moved abroad went into construction, now that the housing boom is over there is not much manufacturing for them to return to so they are structurally unemployed. “The stimulus package is not working,” the stimulus package was designed to generate consumption; much of what we consume is produced abroad so much of the stimulus money was ultimately siphoned off by our trading partners. “This recovery is anaemic and not creating enough jobs,” Q2 GDP was revised down from 2.4% to 1.6% because of the trade deficit was larger than expected. 0.8% of American GDP is $110 billion or about as much GDP as would employ 1.1 million people. The recovery is creating jobs, but in our trading partners, not here. Yep, there it is beneath the surface, the global free trading system the US built up is causing serious problems for the US worker.

So given that so many of the problems which confront policymakers are linked directly or indirectly to American support for the free trade system why is protectionism not gaining more supporters. I think I know. It’s a unique psychosis that I will call “Smoot-o-phobia.” In 1930 partially as an attempt to raise revenue and partially in an effort to shield American workers from foreign competition Congress passed the Smoot-Hawley Tariff Act. This raised tariffs on imports to the highest level ever and touched off a trade war as our trading partners retaliated with tariffs of their own. World trade collapsed fell 40% from 1930-1933. The Smoot-o-phobes believe that the Smoot Hawley tariff caused this collapse in world trade and which deepened and lengthened the great depression and therefore they believe that the last thing we should do in the middle of a recession is tamper with the global trading system.

I think this argument is nonsense for two reasons. First, though I have a degree in economics I will be the first to agree with my friends from the physical sciences who called economics a social “science.” That is to say, it is not exact. It is very hard to separate causal and coincident factors in explaining a phenomenon. It may well be that the Smoot-o-phobes are onto something with their theory but I would argue that the collapse of the global banking system was a much more powerful factor. As evidence of this I point to the recent credit crisis. Between 1930 and 1931 in the immediate aftermath of Smoot world trade fell by about 28%, between 2008 and 2009 world trade fell by 24% without any additional trade restrictions. Could it be that the greater factor was the collapse of credit rather than the imposition of tariffs?

The second reason is that the position of America in the global trading system in 2010 is completely the opposite of what it was in 1930. The American position in 1930 was analogous to the position of China today, it was the source of most of the worlds spare industrial capacity and a net exporter both of finished goods and raw materials. As such it had a lot to fear from a trade war because its trade balance was a positive contributor to GDP so it really was a Congressional miscalculation (one of many I’m afraid) to pass the Smoot Hawley bill. Here in the future the US is not only not a net exporter, it is running the largest and most persistent trade deficit in the history of the world. If world trade were set to zero tomorrow the GDP would INCREASE, we LOSE money to world trade. I think the Smoot-o-phobia which infects American policymakers is purely psycho-somatic.

Now that I have made my argument I think it is equally important for me to point out what I am not arguing. I am not arguing that limiting the global free trade system is the globally optimal solution. It is not. But it does not matter what is globally optimal, it matters what is optimal for the people who are in control of the largest consumption based economy in the world, namely: Americans. The only way for another country to limit American power over the trading system or to mitigate the effects of American protectism would be for that country to create a similarly consumption oriented economy, something which no one seems willing to do.

I am also not arguing that the limitation should be total. It should be just enough to mitigate or negate the labor cost advantage of the lower cost countries. Ordinarily this would happen over time with exchange rate adjustments but some of our trading partners are committed to maintaining a fixed exchange rate with the US dollar.

I am also not arguing that this would be costless. There would be increased inefficency in the US economy. The evaporation of our trading partners surpluses would also limit the avaliabilty of credit to the American consumer and the American government. I don't think this is bad thing because I think that is coming sooner or later. I simply think that the US would rather be in control of the timing and duration of that credit contraction rather than the bond vigilantes. Taking advance action like this would give the government the initiative.

What’s the cure for Smoot-o-phobia? That’s a complicated question but it comes with a simple answer: elections. The American consumer who benefits from the global free trade system and the American worker who is getting his head caved in by it are the same guys. At this stage of the game Americans need to do a lot more working and a lot less consuming in order to pay back all the money they borrowed over the past 30 years. In order to do this more effectively they need to negate the labor cost advantages of low cost countries which have enjoyed unfettered access to the American market for the past 20 years. To do that they need to place limits on the international trading system.

Lucky for them in addition to being the American consumer/workers these folks are also the American electorate and as such they are in control of the government most responsible for the maintenance of the international trading system. They can therefore vote in people who are in favour of limiting it. As the recession goes on and employment does not recover because the international trading system is limiting the capacity of traditional measures to revive the economy the Smoot-o-phobic arguments are going to fall on increasingly deaf ears and protectionist candidates will begin to win elections. You heard it here first.

Congratulations gentlemen on surpassing Bahrain. Beneath your chairs are some boxing gloves in case any pregnant women try to sit down at your table.

2010-09-01T21:53:00.000-07:00

So I’m back from the break now and ready to go for September. A lot has happened in the interim so I have a lot of writing to do. But before I get into the bigger issues I want to write about some of the smaller, less noticed ones.

Speaking of small, Bahrain was downgraded by Moody’s last week. I found this out by reading an article in The National that was positively dripping in schadenfreude. My favourite part of the article was where they called the downgrade the first fora GCC government. Well, I suppose that’s true if you don’t count the total obliteration of the various Dubai government related entities and the restructuring of Dubai World. Personally I think those things do count but I’ll not quibble with the national. The GCC has now seen its first sovereign downgrade of the financial crisis.

Though this is not big news in the way that the downgrades on the Eurozone periphery have been, it was only one notch and is still investment grade, the report is still interesting. They point out that Bahrain has a 7% of GDP budget deficit and has relatively little in the way of foreign exchange reserves or sovereign wealth funds in contrast to Saudi Arabia or Abu Dhabi. This means that should the world economy slo significantly and drive down oil prices Bahrain will be in a bind without much room to manoeuvre. Interestingly they also make the point that political tensions between the Shia and Sunni on the island are a source of potential instability. Most interesting are the points they make about the financial sector.

Bahrain has long been a financial center for the Gulf and Moody’s seems to argue that the banking sector in Bahrain is a liability both because it is too large and because it is too small. It is too large because with bank balance sheets three times the size of GDP any serious deterioration of asset quality might require government intervention which would be beyond the capacity of the government to intervene given its already stretched fiscal position. At the same time Moody’s says that the banking sector is not large enough to diversify the economy away from its dependence on hydrocarbons. So the Bahrainis seem to have sought to diversify their sources of revenue but instead have simply added another liability, at least according to Moody’s.

Well I can tell you why the banking sector in Bahrain is not big enough, it’s because Dubai has totally stolen its mantle as the financial center of the GCC. Sure there are still a lot of bank assets in Bahrain but virtually all the growth in financial employment in the GCC has taken place in Dubai over the past five years. Some have even consolidated their operations in Dubai and closed their Bahraini operations, or rather left a skeleton crew in Bahrain to appease the government but functionally consolidated in Dubai.

Why is this? I’d say it’s for two reasons. One is that when Bisher and Dr. O were not too busy lighting Sheikh Mohammed’s money on fire with various investment schemes or paying themselves substantial bonuses for managing those fires, they were luring the wide world of finance to the DIFC. The DIFC legal system has turned out to be kind of a bait and switch but when choosing a location once you have taken the bait, it’s hard to switch. The other reason is that it is a lot easier to attract expat knowledge workers to Dubai than it is to attract them to Bahrain.

There are many reasons for this. Some people will point to the infrastructure, which is impressive. Personally I think Dubai is likely to be the red headed stepchild of the capital markets for some time to come so I doubt that they will be adding to this but the silver lining to the collapse of the real estate market is that there is still a lot of spare housing capacity in Dubai so they actually don’t need to add to it. Others might point to the relatively permissive moral environment of Dubai. This is a factor as well, bankers and traders like a martini now and again. Their girlfriends like to be able to weak little bathing suits on the beach and occasionally kiss their significant others in gratitude for rescuing them from the rain of London. To be sure the atmosphere is a bit chillier now than it was a few years back but it’s still not Saudi Arabia.

While the liberality and infrastructure of Dubai are impressive I don’t think they are the primary reason why it is easier to move people to Dubai than elsewhere in the Gulf. I think the reason for that is the human infrastructure. Over the past ten years Dubai has achieved a critical mass of expat human capital. People want to live there because everyone else does. It has become the regional headquarters for so many multinationals that the expat social milieu is not dominated by a particular industry. Finance is prominent to be sure but there are foreigners there in the media, pharmaceuticals, infrastructure, consulting, you name it. It’s a much more interesting place to live than any other city. Dubai has created this environment through massively leveraging itself to build the physical infrastructure and marketing the hell out of itself in the West. Those two things are not sustainable now that the good ship Dubai has struck the restructuring iceberg but the human architecture that it has build should be able to outlast either one of those two things.

If Dubai is ever to recover it ABSOLUTELY must retain its preeminent position as the place for international expats to live and work. Thus I was shocked to read a recent news article about an assault on expats in Dubai by three Emirati men. At the IKEA cafeteria a Canadian investor man and his marketing manager wife sat down at a table for twelve which was partially occupied by Emiratis. The Emiratis claimed the entire table and demanded the couple depart. The woman, who was seven months pregnant and has doubtless been walking endlessly around the IKEA which is designed to be walked around endlessly demurred the Emirati brothers proceeded to beat her and her husband senseless. A Syrian man came to the rescue when the Emiratis began beating the unconscious husband with a chair and they beat him senseless as well. They broke the jaw of the pregnant woman and there is some ambiguity as to whether or not her pregnancy was compromised. The last thing her husband saw before being knocked unconscious was one of the Emiratis beating his wife and blood rushing down her legs. My guess is that if her pregnancy had not been compromised the courts would have made a point of noting it as a mitigating factor.

Obviously an attack on a pregnant woman by three Emirati men in the middle of an IKEA cafeteria is horrific in its’ own right and pretty hard to understand. What’s more, Dubai is completely dependent on foreigners to do most of the work, to move there, buy apartments and set up businesses in order to dig Dubai out of its deep dark hole. You would think that the authorities would deal harshly with the culprits. Besmirching the reputation of Dubai as a tolerant multicultural hub poses an existential threat to Dubai itself. Alas, it is not so. The assault occurred in June of 2009, the first hearing was in August 2010. All three assailants are free men in a city where hundreds are in prison for bounced checks. Two of them failed to even show up for the hearing, the judge questioned this but was not given an explanation and no action was taken. It would seem that the Emiratis don't think this is a big deal or that they will suffer any consequences. They may well be right.

It’s their country, they can do what they want, but if you ask me this is no way to run a country completely dependent on its reputation among foreigners. As sad as the article itself is the comment at the bottom from an Emirati: “they should have moved.” They probably will, and not to the next table but rather to the next country and if enough foreigners decide to follow them the creditors will beat the hell out of Dubai.

August Holiday (Apologies for the silence, I have a few people over right now)

2010-08-25T17:44:00.000-07:00

Even if the volume goes to zero we can still hang out here right? I mean, we don't want to let these awesome leather couches go empty...

2010-08-17T19:06:00.000-07:00

There have been some articles recently about the plight of brokers in both Dubai and Abu Dhabi. Initially these were reports of how volumes were tapering off as we move into Ramadan. While business networking takes off during the Iftar hopping season (I wish there was an analog to this in the West) trading on the regions exchanges tends to slack off. This volume decline and the economic effect it is having on the brokerage industry in the Emirates has attracted the attention of both Bloomberg and The National as well it should because it says something about Ramadan, more about the brokerage industry in Dubai and a great deal about what the function of equity markets in the region is and what it could be.

There are any number of reasons why people would want to scale back their trading during Ramadan. Perhaps in the same way that you shouldn’t go grocery shopping while you’re hungry maybe you shouldn’t go stock shopping while you are denying yourself basic sustenance. Maybe that dry feeling you get in your mouth when you’re betting the ranch on Saudi Livestock is particularly arid when you can’t drink anything till sundown. Or maybe people feel closer to Islam generally and so are less comfortable making or taking non-Sharia compliant margin loans. Perhaps the speculative nature of trading GCC shares seems a little too close to gambling for people to be comfortable during Ramadan. Perhaps the generally higher level of sobriety keeps people away from buying shares. Or maybe this year as Ramadan falls in August everyone is simply in Marbella or the Cote ‘d Azure or Geneva so no one is around. It’s been interesting to watch the number of people logging onto my blog from the marina in Monaco spike. Whatever the reason, volumes are seasonally light.

The articles in the press don’t stop there. Volumes in the Emirates have fallen off a cliff putting an extremely serious squeeze on the brokers forcing a great many of them to close their doors. Personally I have mixed emotions about this. I think I met with 80%-90% of the brokerages in existence between 2005 and 2008. The market structure was extremely fragmented, there were something like 95 brokers registered on the DFM and the largest one had a market share of under 15% the top ten were less than 30%. As a person trying to sell connectivity to the DIFX in November of 2005 this was deeply tragic because it meant I literally had to meet with everyone.

Things got better once my firm established our own market access business which we used to connect international investors to local markets channeling billions of dollars from abroad into local markets (this ended in tears I'm afraid.) At our peak we were trading between 10-15% of the daily volume in Dubai, Abu Dhabi, Qatar and Bahrain. It sounds crazy I know, but we were. International investors could not get enough of the place once upon a time. Naturally we became an extremely large brokerage client and that made the meetings a lot easier. They got easier still in the run up to the DPW IPO. It’s always easy to have a meeting with someone when you’re paying 10% of the brokerage in the entire market and you are handing out IPO candy.

So in this way I became acquainted with the entire brokerage industry in Dubai and Abu Dhabi and let me tell you there was quite a variety. There were several which operate efficiently with a wide range of services and had moved from being mere brokerages to full service local investment banks. There were some firms which focused on electronic execution of their client orders some of which had developed surprisingly sophisticated technology in house and which we viewed as potential partners. There were of course the brokerage arms of the large banks which thanks to their huge distribution networks were printing money. We had such confidence in these firms that we were able to put them together into a retail syndicate for the DPW IPO which in all operational respects was handled as if it were a major market IPO. Though these firms were pleasant to work with they were not the most interesting stars in the UAE brokerage constellation. Those were the bucket shops.

One of the trading classics is a book called “Reminiscences of a Stock Operator” a thinly disguised autobiography of Jesse Livermore. He began his career in bucket shops. Bucket shops purported to be brokerages but never actually executed client orders on the exchanges. Rather they operated as casinos where the “house” took the other side of every trade and the margin rules were such that the clients were systematically wiped out. Despite or perhaps because of this the bucket shops became a place where local men would come to socialize and talk about stocks cheer each other on and share their sorrows. Like a casino it was as much a social activity as an economic one. Eventually in the US the authorities caught on that these were merely casinos operating incognito and shut them down. Not so in Dubai. In Dubai they multiplied like rabbits.

I must have visited several dozen during my time there. Occasionally they would be in office parks but my favourites were the ones in out of the way places: above an auto-repair shop, in the back room of an auto-dealership, behind a narrow door in a rabbit warren of alleyways in Bur Dubai or Deira. The kinds of places that when you ask the cab driver for them you get that Pakistani look of bewilderment, followed by desperation, followed by resignation that these foreign idiots have asked for yet another non-existent address and are going to go ballistic when the meter runs out of digits because it cannot be found. When you finally did find the place it was always the same thing.

There would be an extremely affable GM who would be calling you “habibi” before even shaking your hand. He would talk about the massive expansion he was planning, about how his firm would be the next EFG, Rasmala, you name it. These people drank the Dubai cool-ade by the gallon. Dubai would be the next Singapore and after that New York and it would be done by firms like his led by men like him. He’d introduce you to a few clients all of whom he assured you may not look like much but this was because they were overly modest in keeping with the tenets of Islam. This one here owns 3% of Emaar, that man in the shabby dishdash negotiating with the teaboy routinely flips millions of shares of Arabtec. Unbable to contain himself he’d insist on giving you the grand tour and show you what luxury you yourself might be able to trade in if you became a customer.

There would be at least one, often several strikingly beautiful receptionists, Arab girls from Morocco or Lebanon. I remember thinking that the Niqab made some sense because if Arab women were all like this it would be understandable that Arab men would be perpetually at war with each other over them. You would then go into the main room which would have plush carpeting and huge comfy leather sofas, a lot of fancy trading screens and TVs tuned to CNBC Arabia or Bloomberg TV. There would be tea boys and waiters aplenty to bring you some coffee or a snack to maintain that trading stamina. Some were built like nightclubs with an exclusive VIP area for the “whales” with even comfier sofas, more tea boys and gaudier decoration. There was even one, now defunct, that had a shark tank in the middle. “Our clients are the sharks of the market.” Said the GM. That may be, but they were sheep for the shearing for the brokerage.

These weren’t bucket shops in the traditional sense where house bet against the customers and rigged the leverage to blow them out. They did however achieve largely the same effect with high fees and by using the rumour mill to generate high trading volumes. My first boss on the Merc floor had a saying which seemed to me pretty useless at the time: “Bulls and bears make money, sheep get sheared, and pigs get slaughtered.” If the customers were the sheep the brokers themselves were the pigs. They ground up the clients and now the clients are gone and with them the volumes. But this is a tiny part of the story. The bankruptcies of the bucket shops and the demise of their denizens are merely a symptom of the deeper illness that afflicts the equity markets in the GCC. The real problem is not that a few impresarios have perverted the capital markets in order to separate a lot of fools from their money. The problem is that economically that is the only function they perform.

As I have written before the IPO market is a rigged game designed to spread the wealth of the business owning class to the masses. As a result all the IPOs are systematically underpriced and thus no rational business person would voluntarily sell equity in a profitable business via that method. This reinforces a cultural aversion to surrendering control or giving up equity, particularly among the merchant families. As a result the public equity markets in the UAE do not perform the important capital raising function that they perform elsewhere with massively negative consequences for the economy of the Gulf as a whole. It is impossible to exaggerate the degree to which this weakens the economy of the gulf because it forces all the merchant families to fund themselves with debt or with retained earnings. To some extent this is offset with government largesse but that creates a dependence of the merchant families on the ruling family. This suits the ruling family just fine but helps explain why there are so few globally competitive firms which originate in the Arab world.

Even once corporations are public GCC equity markets don’t provide a decent valuation function. There is no operational capacity to borrow or lend shares so it is impossible to short them. What you get as a result are a string of euphoric manias followed by buyers strikes which lead to collapse. This is why you can have things like Aabar and Kingdom trade so far away from the value of the underlying assets they own. They don’t function as a market for control either. Especially where the state takes a view as to what the outcome should be. Think of the decision of Sheikh Mohammed to form a national champion with the forced merger of National Bank of Dubai and Emirates Bank. The merger was announced before the terms were decided. The shareholders? No say. The original Arabtec merger? Abu Dhabi decides it wants something, it gets it. The shareholders? No say. The Aabar delisting? IPIC and then ESCA make arbitrary decisions, the shareholders? No say. Want to try to take out a local company as an international player? Forget it.

So the macro bulls and the bears are kept out of the equity markets in the GCC. This leaves pigs and sheep for the sharing and the slaughter. And maybe, before long, not even them.

UAE Banking Stress Tests brought to you by the shadow central bank: Shuaa Capital

2010-08-10T11:28:00.000-07:00

When I first saw an article calling for stress tests of the Gulf Banks I laughed. My opinion was that the Western Governments that had enacted them largely to try to counter the market suspicion that despite the massively unpopular but massively necessary injections of capital that the banks were still in serious trouble. Knowing that they would struggle to muster the political will to rescue the banks again they decided to try to show the world that no more injections would be necessary and then market confidence might build on itself. It seems to me that this is totally unnecessary in the Emirates.

Given that the Emirates were unwilling let Dubai World fold, what are the odds that they’ll let the banks collapse? Zero. More to the point, since the banks will ultimately rely neither on the markets nor the voters for their rescues what is the point of reassuring either as to their health? At the end of the day the largesse which rescues the banking system will come from the Al Nahyan who answer to neither and indeed answer to no one. Thus rather than a statistical shock to the values of the assets on the balance sheets of the banks what a would-be stress tester would have to determine was the odds of the various banks winning the coin toss of Al Nahyan support. Given the fact that they allowed Dubai to pour $15 billion into the Nakheel black hole my guess is the coin they’ll use for banks has heads on both sides.

Apparently the UAE central bank agrees with my conclusion if not my reasoning and has decided not to conduct these stress tests. So it has fallen on the shadow central bank of the UAE, Shuaa Capital, to conduct them. I should say that I have a lot of respect for Shuaa. When I first got to the Gulf I tried to work out partnerships with a lot of local institutions whereby my firm would provide intellectual capital and they would provide the local connections. At the time intellectual capital was rarer than local connections so the deals I struck were generally pretty favourable. When I met with Shuaa they sent me packing. They had intellectual capital in spades which they showed me over the next two years as one of our stiffest local competitors for the equity market access business. They had a vastly more nuanced understanding of the legal and regulatory environment. They knew, in a way that my compliance department in Frankfurt could never know, that you can cross the lines but you can’t cross the men who draw the lines. They were a well led and effective firm.

They’re no fools with regard to how they played the stress tests either. The headlines in all the newspapers about it read in one form or another: “UAE Banks well capitalized.” I’m sure that the rulers and the regulators read that with pleasure which should serve the partners at Shuaa well indeed. Add to this the fact that the UAE Central Bank is now off the hook and it’s quite the coup indeed. Having read about them in the papers I was tempted to dismiss them but they’re pretty interesting and reward a good read. Despite my general scepticism of stress tests generally I think Shuaa did a good job. I could pick nits with their methodology. For example they limited themselves to loans made at the peak of the real estate bubble which is a de facto assumption that real estate prices which will not continue to decline, a precarious assumption in my view. I don’t want to go into the minutia of the tests but rather point out some features that I find salient.

The first thing I find interesting is that the headlines about bank solvency are a bit misleading. On the one hand they rightly make the point that the capital requirements of the UAE are more stringent than those of Basel II and that under none of their scenarios do the banks violate the Basel II capital requirements. They go on to say that under most scenarios the banks they survey are “on average” adequately capitalized but only “on average.” In every scenario at least one of the banks (ADCB) requires additional capital. Under their worst case scenario several do, up to $4.3 billion. They then say that this is well within the power of the authorities to commit to the recapitalization of the banks. Their confidence therefore is not necessarily in the banks themselves but rather in the governments’ willingness to supply that capital. I agree with this but it is not the same thing as saying the banks are well capitalized.

What I find more interesting than the report on whether the banks are adequately capitalized or not are the diagnosis of the problems which are affecting the UAE economy and the prescriptions for how the government can use the banking system to reverse them. First off they point out that the economic recovery in the Emirates has been sluggish and they lay the blame for this at the feet of the banks on account of the fact that their provision of credit to the private sector has fallen off a cliff. They point out that the banks have already been recapitalized once with an injection of cash from Abu Dhabi and a blanket guarantee on deposits. They then show that since the bailout the banks have focused on lending to the government or to government controlled entities. They then bravely assert that this is not evidence of risk aversion on the part of the banks but rather that the banks are owned by the government or allied families and they are consciously directing the flow of capital to themselves.

They then go on to describe two courses of action for the government to take to free up lending. The first is a more aggressive recapitalization of the banking system. They look at the Spanish and the Irish examples and strongly prefer the Irish case wherein the government swapped its own paper for the distressed assets held by the banks, effectively simultaneously recapitalizing and de-risking them. This is all well and good but it seems to me to not really go to the core of the problem. If the main issue is that the government and the merchant families are directing lending to their own enterprises then why would recapitalizing the banks change that?

I personally think that the main issue is neither that the banks lack sufficient capital nor that what capital is available is being directed to the government. Those two things may be true but the real problem is most likely that the excesses in the real economy and asset prices that had been built up in the system from 2005-2008 have still not yet been worked out. You can see this from the recent Aabar downgrades. Though I do not doubt the influence of the ruling and merchant families over the direction if credit flows I do actually think they are likely driven by risk aversion as much as by command.

To this end I think Shuaa makes a more effective recommendation when they suggest deep structural reform which would encourage private and foreign investment into the Emirates. Unfortunately all they do is use the favourite buzzwords for this “transparency” and “improved governance” without making any specific recommendations. I can understand why they keep it general rather than specific. This is because everyone knows what has to be done, but nobody wants to do it. This is because the only way to create a stable and predictable environment in which to deploy capital would require submitting the law of the ruler to the rule of law. No more arbitrary arrests of out of favor burecrats, no more turning a blind eye to local merchant families who rob investors blind. So far the powers that be have not connected the dots between these structural problems and the lack of access to capital but they are there.

Shuaa says some brave things in their report about the solvency of the system and the degree to which it actually responds to the market. They hint at what really needs to be done but don’t spell it out. Once again Shuaa crosses the line without crossing the men who draw the lines.

“The Barazi Bruiser” encourages the "DIFCI Demon" to settle, or vice versa

2010-08-04T17:33:00.000-07:00

When Muhammad Ali converted to Islam it was controversial. Ernie Terrell, an opponent, kept calling him Cassius. In 1967 Ali beat the hell out of the guy while yelling at him the whole time “What’s my name fool!?! What’s my name!?!” Ali, who won 2/3 of his fights by KO, never delivered a knock-out blow but rather won by decision. It’s been speculated that he did this in order to deliver a longer beating. As I read the Barazi response to the DIFIC counterclaim I imagine his attorney Imran Shafiq shouting “What’s my name fool!?! What’s my name!?!” at his computer while they delivering a solid beating to the DIFCI case all the while keeping his knock out blows in reserve.

The Barazi response opens with a description of Barazi’s background demonstrating that he is eminently qualified for the roles he held at DIFCA and DIFCI. It then goes into the detail of his compensation and his contract reaffirming what his salary was, its compensation, his entitlement to severance. Nothing too exciting. It begins to get interesting when it quotes the DIFIC Articles of Association to make the point that the Governor of the DIFC who is also the Chairman of DIFCI, that is to say Dr. Omar, who has the final say in the management of DIFCI and all other managers are appointed by and subject to his authority. This will be important later.

Next they use inconsistencies in the accounts of the DIFCI managers and the DIFCI counterclaim to shred the chronology and legality of DIFCIs actions in placing Barazi on the “investigative leave” and refusing to pay him. I highlighted some of this in an earlier post but the attack Shafiq launches is far more compelling and better researched. His alternate narrative is backed by quite a bit of documentation and a great many quotes from DIFC laws and DIFCI employee manuals. The core of the argument is that the claims of DIFCI are based on a manual that was not in force at the time of Barazi’s dismissal.

In the narrative that emerges, the people who took over the DIFC after Dr. O was forced out wanted to get rid of the old guard in a hurry. It looks like they did this without fully consulting Barazi’s contract, the DIFC employment laws or the DIFCI employee handbook. I have some sympathy with this, the guys who took over had bigger fish to fry and probably figured that they would get Bisher out of the way ASAP and cross the t’s and dot the i’s later. They didn’t count on Barazi trying to shake them down for $500,000. If they had left it at that and just disputed the circumstances of his unpaid leave then we would be having a boring discussion about which version of the employee handbook is relevant. They didn’t stop there.

No they went the extra mile and rather than debate the minutia of DIFC employment law their line of argument was that Bisher had been engaged in a fraud, or series of frauds and therefore was entitled to precisely zero and, sooner or later, would probably find himself standing tall before the man. Of course once you accuse someone in Dubai publicly of fraud they know what happens next and they’re going to pull out all the stops to defend themselves which is what Barazi and Shafiq do in their response.

The first thing they do is point out that KPMG has its own reservations about the investigation and that the allegations of the DIFCI are being made on preliminary reports all of which are heavily qualified by KPMG. Then the go after each item in particular.

At the very beginning of the discussion of the “fraudulent bonus” of 2007, they make reference to the fact that The Governor of the DIFC could award bonuses at his sole discretion. This was clearly a major error in the design of the governance of the DIFC but Barazi correctly points out that “Mr. Barazi was not responsible for the system by which such responsibility and accountability lay in the Governor alone.” Quite right, my guess is the governor isn’t responsible for it either despite being its chief beneficiary a point I make in an earlier post.

They then categorcally and effectively deny a litany of accusations that the DIFCI alleges but does not substantiate. For example the existence of a conspiracy between Dr. Omar and Barazi is alleged but no evidence is provided other than the fact they both received bonuses which they might well have done without a conspiracy.

The central attack on Barazi in the counterclaim is an allegation that Bisher justified a bonus on the strength of a $60 million realized gain when in fact the DIFCI had an $80 million loss. The DIFCI insinuates that this is a misrepresentation similar to accounting fraud. The argument on the DIFIC side is deceptively simple and the Barazi counterargument is obfuscatingly complex. In sum Barazi makes the following arguments:

1.) It is not formally necessary to actually make money to be paid a bonus
2.) Dr. Omar could decide bonuses at his sole discretion
3.) DIFCI executives benchmarked themselves against payout rates based on a study by Manpower (which implied a 20% payout rate) and their own experience of private equity (which implied a 50%) payout rate.
4.) Given these benchmarks their decision to pay themselves 10% of realized gains after $60 million was conservative.
5.) The decision to base the payouts on realized gains was made because it was conservative
6.) The payouts were made based on unaudited results which it was believed would not be materially different once the audit was completed.
7.) The discrepancy which is pointed out by the DIFCI counterclaim is the result of confusion about the chronology of when the audits were completed and...
8.) Some confusion which arose regarding the accounting treatment of two very large transactions: Bourse Dubai and the Deutsche Bank trade.

A few things stand out. No private investor would pay Bisher and Dr. O 50% fees to manage a PE fund. They had no track record and, as events have shown, would have been wiped out before they were able to create one. That said I personally don’t think their compensation of 10% was too outrageous. I have no view of the issues regarding chronology or realized vs. unrealized gains. Personally I don’t think they’re material. I do have to say that the fact that they contributed the DIFX to bourse Dubai at a valuation in the hundreds of millions justifies a bonus at least twice what they actually got. Don’t get me wrong, I dearly loved the DIFX and I spent nearly a fifth of my working life on it so I have every reason to claim it was more valuable than it was but to get the price they got for it was a miracle.

All in all I think they at least do a pretty good job of explaining in minute detail why the simplistic DIFCI contention of fraud is not what it seems on its face and this should sow a lot of doubt in the minds of the judge.

DIFCI also alleges that Barazi asked for a personal loan after they had been banned and characterizes this as a breach of his fiduciary obligation. More damning they allege that he agreed to buy billions worth of off plan real estate without conducting due diligence another grave breach of fiduciary obligation. The defence regarding the loan is pretty straightforward. Dr. Omar had the right to grant them, he did and Bisher paid it back within weeks of being granted it. Case closed. They also make short work of the allegation of the Pearl due diligence by producing text from the agreement that allows DIFIC to back out ex post facto if their due diligence turns up a material issue even though it is going to be conducted after the first payment is made.

So, all in all, the response from Barazi and Shafiq is a pretty effective refutation of the counterclaims of DIFCI. In cases where they can just shoot down the DIFCI they do it with dispatch and in areas where there is some nuance they seem to have used the “if you can’t convince them, confuse them” strategy so sow doubt about the veracity of the DIFCI claim. As effective as the overt defence buried in the document are two covert defences which will come into play if the DIFCI press their case.

The less powerful one partially emerges in the section on the due diligence. The document points out that in the fall of 2008 the Dubai real estate market was in free fall and the prospects for Cityscape, the annual real estate conference were grim. Then it says “Mr. Barazi was instructed that DIFCIL should make a substantial property investment in a development in the Dubai Technology and Media Free Zone known as “Dubai Pearl” and owned by Pearl Dubai FZ LLC which might be announced before the start of Cityscape in that year." This is not a surprise but it sure does shed some light on why that due diligence was not done before the transaction was executed. What it does not shed light on is who precisely it was that instructed Barazi: the sentence is in the passive voice. The subject is secret, that is until Barazi and his lawyer choose to reveal who precisely it was that was seeking to have DIFCI create a false impression of real estate demand in Dubai by channeling billions of dirhams borrowed by the state into privately owned off plan development. Whoever that was now has a real interest in Barazi not getting prosecuted.

My favourite however comes much earlier in the document. In my first post on this subject I thought it was really odd that the DIFCI counterclaim cited a Gulf Business story about the release of Dr. Omar as evidence that Barazi should have known that he was under investigation. I thought that was preposterous and so does the Barazi legal team who point out the obvious that it does not oblige him to admit any knowledge of the “nature or extent of such investigations as may have been and/or still are being conducted by the DGAT, or as to the alleged charges brought against Dr. Omar or any other employee of the DIFC.”

That’s all well and good but the final clause conceals the knock-out blow: “If and insofar as DIFCIL may seek to assert the truth of (i) any such report (ii) any such investigative findings and/or (iii) any charges that have been laid against any person, they will be put to strict proof of same.” (emphasis mine) This is code for: “if you attempt to pursue me for fraud I will use the higher burden of proof within the DIFC legal system to attack your actions against Dr. Omar in Dubai proper and, (considering we can assume Barazi and Dr. O are in constant contact,) I will very likely be able to show that YOUR ACTIONS AGAINST DR. OMAR HAD NO LEGAL BASIS WHATSOEVER AND THEREFORE ARE INDISTINGUISHABLE FROM EXTORTION.”

What’s my name fool. What’s my name.

So then it will come down to just how much embarrassment the Dubai establishment is willing to take at the hands of Bisher Barazi. I’m not sure, what will happen. They might cave and pay him to go away, or they might say, “Listen little man, its not a secret that this is an autocracy and we can dispose of Dr. Omar as we like. As for public opinion, try to imagine how little we care. As for you, if we don’t win in the DIFC we’ll get you in Dubai proper so either way you’re going to jail. Enjoy.” It may turn out that Barazi, with his elaborate overt and deviously subtle legal arguments, has done nothin more than bring a very elegant knife to a gun fight. Either way the stakes are high for all involved. It’s going to be interesting.

So I'm not sure what a "Cascade Agreement" is but I think it has something to do with a waterfall. Hey! Look! There goes a Damas shareholder!

2010-08-03T22:53:00.000-07:00

The long suffering shareholders and creditors of Damas are now able to see the full extent of the damage that has been done by the Abdullah Brothers. The annual report puts a brave face on things. With justifiable pride they point out that the company earned 9.8 million AED not including extraordinary items. This grain of good news needs to be taken with a pinch of salt, or rather a pillar of salt because those extraordinary items weigh in at 1.9 billion AED. So if Damas can keep up the good work, they’ll have repaired the damage from these one off write downs in 200 years. Unfortunately for the creditors, and fatally for the shareholders, Damas’ auditor said the company has to come up with a restructuring plan by the end of the month or it may close its’ doors.

I have to admit that in continuing to write about The Great Damas Heist I feel a little bit like George Orwell in “Shooting an Elephant.” I’ve written so much about it that people seem to expect me to continue even though the story has its’ edge because it is obvious how it ends. Alas, my inbox is full of requests, and some of you are new to my writing through its recent syndication. So I’ll point out a few things and tell you how it’s going to end.

The first thing you have to do is get around the Dubai Newspeak that is used to describe what has gone on with regard to the “unauthorized transactions.” They are universally described in the Damas documents and in the press as monies “borrowed” or “owed” by the Abdullah Brothers. The documents in the DFSA undertaking demonstrate that the at the time of the transfers the Abdullah brothers were not obligated to pay the monies back nor were they charged interest. From my perspective an unauthorized interest free loan for an indefinite period is called “theft.” This makes it easy to interpret their actions through the simple expedient of lip reading. If their lips are moving, they’re lying. If their lips are not moving, they’re stealing.

The next thing you have to do is connect the dots that the DFSA is unwilling and the Dubai press is unable to connect. The first thing that stands out is how ridiculous the continued involvement of the Abdullahs as advisors to the company because of their “relationships” and “reputation.” Their reputation for fraud caused a massive liquidity crisis.

The brothers “borrowed without authorization or interest for an indefinite period” or “stole” depending on your frame of reference, two tons of gold from Damas. Interestingly it turns out that the gold that the Abdullah brothers stole was not even the property of Damas. Damas had borrowed it from other merchants and banks. When the other merchants and banks discovered that the Abdullahs were able to simply drive up in a truck and make off with the gold they had lent to Damas they quite reasonably either called in or demanded substantially greater security against the loans. This in turn caused a massive liquidity crisis at Damas which itself resulted in further losses.

It would seem to me that given the fact that the Abdullah Brothers reputation for theft has made it impossible for Damas to acquire the raw materials of its main business on commercially favourable terms would be a pretty good reason to exclude them from the management of the company even in an “advisory” capacity. The people who say that the business depends on reputation are not wrong but the Abdullah’s have a reputation which is commercially fatal to the business of Damas, yet there they are back in the saddle. Now wait a minute you say, doesn’t Damas have an entirely new board? Aren’t the Abdullah Brothers working in a “non-executive” capacity? Surely this will put the gold lenders at ease. Personally I don’t think so. Anybody who has two tons of gold stolen out from under them is going to be understandably sceptical. There was a board at the time the Abdullahs absconded with the gold last time, what makes this board different. They didn’t even have the willpower to stand up to the Abdullah Brothers and keep them out. I’m sure it wasn’t their idea to bring them back in.

There are also some interesting items in the write down list. One of them is the $80 million Dubai Ventures loan. This was money that the Abdullah Brothers had Damas lend to Dubai Ventures, a private equity firm, to invest in the Damas IPO when it turned out that not enough buyers could be found to give the Abdullahs the valuation they wanted. This created the illusion of interest at the higher price and enough of it to clear the 25% hurdle of independent investors necessary to conduct an IPO on the DIFX. Of course since the shares were purchased with Damas’ own money they were not at all independent. This effectively rigged the book build (auction) and forced the foreign investors to overpay. This helpfully increased the amount the Abdullah’s were able to steal. And of course whose money was used to force the shareholders to overpay? Thiers. At least that’s what it looks like now that Dubai Ventures won’t be paying that loan back. Who owns Dubai Ventures? Dubai Holding. Who owns Dubai Holding? Sheikh Mohammed bin Rashid Al Maktoum the Ruler of Dubai. Naturally Sheikh Mohammed is not going to take the hit, the Damas shareholders and creditors will be doing that. Dubai wins again! Thanks for playing gentlemen shareholders. Can we interest you in some off plan real estate?

Another interesting item that they are reserving against are the shares of Damas that the Abdullah Brothers pledged in the event that they cannot repay the loans. Apparently there are some issues with transferring those shares and so they cannot be properly valued. I pointed this out quite some time ago.

Finally, and unsurprisingly Damas thinks it wise to reserve against the possibility that the Abdullah Brothers will not in fact pay back the money and the gold that they “borrowed indefinitely with neither interest nor authorization.” This makes a lot of sense considering that they’re quite a bit overdue with regard to their payment obligations under the Settlement Agreement. There is even some talk of shredding the Settlement Agreement upon which the DFSA unenforced enforceable undertaking is based in favour of something called a “Cascade Agreement.” I’m not really sure what that means but I like the sound of it. It reminds me of going over the falls in a barrel. Joking aside apparently the Abdullah Brothers owe money to other parties aside from Damas. Apparently what they did was steal money from Damas, use that money as a down payment on some real estate and borrow the rest of the purchase price against the asset. That means that the Abdullah brothers, and with them the Creditors and Shareholders of Damas, are behind the banks in the capital structure of these investments. This is what is meant by the Dubai Newspeak “uncertain title.” If you put 20% down on real estate that has declined 50% in value using funds you have stolen from a company you control your equity has been wiped out and so you no longer have title. Nice.

It seems that the parties involved have decided to indulge themselves in the fiction that if they just don’t sell now but wait a while all will be well. While it is perfectly understandable that this is not the optimal time to liquidate Dubai real estate, and I’m sure the banks would agree, the fact remains that this is beside the point. If the Abdullah Brothers investments in real estate using stolen and borrowed funds are underwater so be it. The remainder of the Abdullah fortune should be being auctioned off and the proceeds should be going to Damas. That is not happening. The fact that the investments made with the “unauthorized interest free loans of indefinite duration” have been wiped out does not mean that the Abdullahs did not steal the money. They did. They should be on the hook for it and the DFSA and the Dubai Courts should be liquidating their personal assets in order to pay back the creditors of Damas. ALL their assets not just the ones that they purchased with Damas money supplemented by banks.

But of course this will not happen. The Abdullah Brothers are rich and connected Emiratis. They won’t have to sell their assets, they stole almost 70 years worth of earnings from Damas in 18 months that should last them a good long time. The Damas Creditors will probably roll the debts in the hope that something can be collected over time but they will be disappointed. The shareholders will be wiped out entirely. This is because the shareholders are unconnected international investors. They bought into the idea that inside the DIFC they would be operating in a legal environment that would protect them supervised by a regulator that was operating according to international best practice. Well they won’t make that mistake again.

Ban the BlackBerry today, keep the Indian Navy Away-- A fanciful conspiracy theory from wallstwtf

2010-08-02T09:20:00.000-07:00

I want to write a few words about the potential blackberry bans in the UAE and potentially Saudi Arabia. As a person who sleeps with my blackberry under my pillow my first reaction was one of horror at the idea that the blackberry email functions will no longer work on the UAE and perhaps Saudi. On the other hand, I do remember how nice it was to be unreachable while I was in the Arab world when I first began travelling there regularly in 2005. So while the downside will be reduced productivity this will be balanced by the chance for the bankers who visit Dubai to get an extra martini unmolested by the folks in back in London.

I want to take a minute to think a little more deeply about what this means. The issue it seems is that the nature of the blackberry encryption and network organization makes it impossible for the Emirati security services to scan the communications of blackberry users without the cooperation of Research in Motion, the maker of the device. What’s more given the structure of the network and the jurisdictions in which RIM operates the UAE is concerned that it might not be able to use the local legal systems in which it operates to compel RIM to cooperate and hand over data.

OK, so it’s well known that the Emirates are absolute monarchies and it’s not really a secret that they monitor electronic communications within their territory. This is evident in a variety of ways from the occasionally annoying fact that many websites are blocked to the extremely efficient exposure of the Mossad hit squad earlier this year which demonstrated the impressive capabilities of the Emirati counter-espionage services. That said I think this episode is still somewhat revealing.

First of all it shows the willingness of the Emirati government to inconvenience the people who make their living and their homes in the Emirates as well as the international business community. There are 500,000 blackberries in use in the UAE or almost 10% of the population uses them. They are particularly prominent among the international business community which has increasingly been making Dubai the regional business hub. It also put the Emirates which have carefully cultivated an image of openness in a position where Qatar, which announced that it has no intention of limiting blackberry use, to tweak them.

This was also sure to get a lot of press, which it is indeed getting. That press is more favourable than say the issues Google had in China but this is largely because of the presumption that the new restrictions will be used to cut down on Islamic extremism and Iranian sanction busters. Interesting how the freedom of speech and the rights to privacy are more important in American adversaries than in our allies. A similar crackdown on facebook or twitter in the Islamic Republic of Iran would no doubt cause a great outcry. Well, as a famous American once said, a foolish consistency is the hobgoblin of little minds.

Personally I think that presumption is largely misplaced, it is not impossible for the UAE to gain access to the data that is carried over blackberries they would simply be subject to judicial review in Canada. Presumably if what they were after were terrorists or sanction busters they could expect this cooperation. No, they want to be able to scan all secrets for the same reason that Iran and China want to crack down on the use of information sharing, they want to stifle domestic opposition. This is an acute problem in the Emirates.

The analogy I like to use for this is Sparta and the Helots. If you are a classical scholar or have watched the movie “300” you will know that the Spartans had the best and most effective army in ancient Greece. Why was this? It was because the Spartans had, years before, conquered and enslaved another people called the Helots. The Helots outnumbered the Spartans by a substantial margin. So the Spartans developed a highly militarized culture which was designed to terrorize the Helots into subservience and it worked. In addition the Spartans were also able to intimidate the other Greek city states eventually destroying the power of Athens in the Peloponnesian War.

The demographics of the Emirates are similar to those of Sparta. The Emiratis themselves are vastly outnumbered by expatriate workers. A few tens of thousands of those labourers are the white collar European or American workers for international firms, who will be most inconvenienced by this. The teeming majority of them however are workers from the subcontinent and Southeast Asia who while substantially better off than most of their countrymen who are still at home are nonetheless at the very bottom of the social ladder in the Emirates. They are therefore potentially the most subversive force with which the regime has to contend and the one with which the Canadian government is least likely to cooperate with wholesale monitoring.

When I first noticed the massive demographic imbalance I wondered why the Emiratis were so militarily complacent. I would have expected mandatory military service and lifetime membership in the reserves in a country where the natives are outnumbered ten to one by foreign labourers who earn less than 10% of the incomes of the locals. Add to this that the mother country of this relatively poor and occasionally persecuted minority is a major power with increasing capacity for power projection. Then someone explained to me the two reasons why this was the case. First, the Emirates are functionally an American protectorate and if there were ever a threat to the regime the American forces stationed there could be relied on to protect the various ruling families against a violent upheaval. The second is that while largely a distant and benign force in the lives of white collar expatriates the Emirati government is a coercive police state in the lives of many of the immigrants from the sub-continent and uses its power of communications to thwart efforts by them to organize.

So why have the Emiratis chosen this moment to square off against RIM over control of the information sent across the blackberry network? Why now and not 2005 or 2007? Could it be that the Gulf Arabs are watching events in the US and beginning to question the American commitment to their security? The American departure from Iraq is imminent. America seems to be reconciling itself to the existence of a nuclear armed Iran. In Afghanistan the destruction of the American commander by Rolling Stone of all thins and the release of 90,000 classified documents by wikileaks is laying bare the fact that American will is being sapped even with regard to the nation from which the 9-11 attacks were launched. Is it possible that these signs of American fatigue in the Arab world are leading governments in the region to realize that they are going to have to be more aggressive in the suppression of domestic unrest solely through the use of domestic resources? It's farfetched but it’s something to think about.

Here's the plan: we liquidate Dubai World in slow motion and hand out the money starting to my left, if the creditors agree they can sit between us...

2010-07-27T12:13:00.000-07:00

Last week there were some seemingly minor developments in the Dubai World saga. These were the Nakheel restructuring plan and the presentation of the Dubai World restructuring plan to the general lending community outside the Lenders Committee which had blessed the proposal back in May. On the surface of it this presentation carries with it no new news, the proposal is more or less identical to what the big lenders agreed.

I’ve written about this before at length, but to summarize, the lenders will be asked to roll their loans out into tranches of five and eight years. There will be no haircut on principal but the interest rates will be cut to 1% on the 5 year tranche and between 1-3.5% on the eight year tranche. Apparently the 8 year tranche will have several choices for the lenders on repayment type and the degree to which there is a “shortfall guarantee.” Presumably the more risk the lender takes the higher the rate. It seems kind of a Hobson’s Choice to me because even 3.5% is substantially below a market price for that risk and the word is that there is some question as to whether the guarantees would be enforceable in UK courts.

So what is different about this announcement than the one that was made in May? Well, several things. One is that the lenders are not in a position to negotiate the terms, it is a take it or leave it deal. The big banks had an opportunity to challenge Dubai on the nature and structure of the deal back in May but they were more concerned about not taking too big an immediate loss. They successfully blocked Dubai’s opening gambit of a partial write down of principal but conceded on the structure of the deal and on concessionary interest rates. By doing this they basically enabled the government of Dubai to drain the DFSF, channel the vast majority of the funds to Nakheel, and through Nakheel to the Sukuk holders and the local contractors which had trade claims against Nakheel. The Nakheel creditors, who are also mostly local are getting a much better deal than the creditors of the parent company. Well that’s what happens when you put immediate loss avoidance ahead of your long term strategic interests but considering that this decision was made by western banks it should come as no surprise.

Interestingly the new sources of repayment seem to acknowledge that Nakheel is doomed and the DFSF transfer was mostly to rescue local firms rather than actually revitalize Nakheel. Back in May there was talk about how the cash injection into Nakheel would enable it to finish it’s projects and contribute to the repayment of the Dubai World parent company creditors. In the new proposal there is a lot more discussion of asset sales, it seems that Infinity and Istithmar will be liquidated entirely and that some of the holders of the Dubai 10 year tranche will be repaid with the sale of “strategic” assets which can only mean Dubai Ports World. There is also some talk of the creditors in the 10 year tranche being paid off “in kind” whether this means shares of DPW or non-existent crescent shaped islands I do not know. My guess is most banks other than perhaps NBD-Emirates would avoid that option.

It also sounds like the tone was a bit more aggressive. The package was delivered as an ultimatum: “Take this or take your chances with a liquidation.” To add insult to injury it has been insinuated that the DFSF may take precedence to the original creditors in the event of liquidation. Additionally the procedure would be executed in the DIFC under a special tribunal established for the purpose rather than the original jurisdiction of the contracts. This is a point made in an interesting interview of the former head of the DFSA. Before the Damas fiasco I would have said they were better off in front of a DIFC panel but given the impunity with which the Abdullah Brothers have gotten to skip out on their payment plan without having to either actually pay their fine or even disclose that plan I think the creditors are quite right to be fearful of what would happen in the event of default.

The question on everyone’s lips seems to be whether the creditors will accept the proposal or not. Personally I think it is a near certainty that they will take it because at this stage they have no other option. Nakheel had already taken its’ cash infusion and divided it among the largely Emirati Sukuk holders and the trade creditors there’s no more help from Abu Dhabi on the way. While it’s questionable that DFSF might be in front of the creditors it’s a good thing that Dubai is swapping its own debt for equity and getting behind the creditors. So what in essence is happening is the DFSF is jumping to the front of the creditor queue and Dubai is getting in back with the banks in the middle. My guess is that this was forced on Dubai by Abu Dhabi: pay us off first, then the foreigners so the UAE saves face, then whatever’s left you can have.

In strategic terms the creditors have no interest in forcing a liquidation because, if you assume that Nakheel will not recover within 8 years, most of the repayments are going to be funded by the liquidation of the Istithmar, Infinity and the eventual sale of DPW and other “strategic” assets. You can think of the restructuring as a slow motion liquidation. A slow motion liquidation is probably much better than a liquidation adjudicated by an authority which is ultimately under the control of the wounded former equity holder. As an added bonus, the slow motion liquidation will be masterminded by Abu Dhabi which has every incentive that it come off because it, is in front of the creditor queue. The bank creditors probably prefer this because Abu Dhabi has more power over Dubai than they do.

The interesting question to me is just how much are the assets that are for sale going to bring in. What will Dubai be left as the equity holder of? My guess is they would be happy if they could pay everyone off with all the international assets and keep JAFZA and Nakheel. It’s still an open question though. This is something that won’t be known for many years. I think the banks mostly did not push harder because most of the people making the decisions know they will be elsewhere when the falcon comes come to roost.

Is a muscular indepedent judiciary coming to a self-legislating financial free zone near you? Inshallah.

2010-07-25T10:39:00.000-07:00

In my last post I suggested that Bisher Barazi get out of town because the DIFCI counter-claim reads more like a vendetta than a defence against his lawsuit to recover his severance pay. It looks like he agrees and according to The National, a respected paper in Abu Dhabi, he has sent his family home to Syria and has himself asked the judge to lift the travel ban on him so that he can defend himself from the comfort and relative safety of Damascus. The judge said no dice. This is a little interesting to me because the judge in this case seems to be adjudicating remotely as well as he conducted the hearing from London by video link. This is of particular interest because the DIFC is qualified to hear commercial disputes only. It can only fine and censure its members, it has no criminal authority and therefore cannot imprison Bisher. It can however refer criminal cases to the Dubai courts for adjudication and enforcement. We may be seeing a preview of coming attractions in the DIFC court’s refusal to allow him to leave, which is of course all the more reason for him to do so.

Additionally he has been asked to detail all his assets and sources of income in the UAE. Still more interesting he is required to demonstrate that he actually owned the villa he just sold. This seems a little odd because presumably the buyer would have also checked that he was buying the villa from the actual owner before handing over the cash no? I think I know what the judge is after in this case. When I was in Dubai I heard a lot of rumors about expat civil servants being paid under the table by the various organizations that employed them with certain high value gifts like villas, cars, and everyone’s favourite: off plan real estate. I imagine that in Dubai proper this is not a big deal but given how much emphasis is being placed on “unlawful compensation” on the former management of the DIFC I think this policy, if indeed it took place, is going to get a lot of scrutiny. If Bisher did receive extra undocumented compensation from the DIFC he is almost certainly not the only person to have done so. It will be a cliff-hanger for everyone else living in gift homes as well. My guess is that more than a few people will be watching the Barazi-DIFC litigation with their real estate agent on hold and their travel agent on speed dial.

Most importantly of all, they will get to watch it. The DIFC Court ruled against a request from both parties to close the hearing to the public. Having had my hopes for the DIFC dashed repeatedly I am wary of reading too much into this but I think it might be significant. Firstly, as a point of journalistic honor I have to concede that as with the ESCA ruling on Aabar, I have perhaps taken too dim a view of the DIFC courts and described them as a tool of Sheikh Mohammed in his quest to punish Dr. O and Bisher. But now the DIFC courts have denied two requests from the government: 1.) that the trial be conducted in secret, and 2.) that they cripple Bisher’s capacity to fund his defence by demanding a 500,000 AED deposit. It may not be a first but having a court in the GCC deny a request of an agent of The Ruler is pretty unusual. Is it possible that we are seeing the creation of a independent judiciary in the DIFC? This will indeed be an interesting court case to watch.

Inshallah the Abdullah Brothers will get their day in court as well if the DFSA ever musters the thrasos to take them on.

In the Emirates, as in life, if you mess with the bull, you get the horns. Maybe moreso.

2010-07-22T12:32:00.000-07:00

In this post I put forth a theory as to why Dr. Omar and Bisher Barazi are in so much trouble. Check here for the previous article.

Sometime in late 2006 or early 2007 I sat in a conference room in the DIFC, the one with the imperial view of the massive construction site which composed the vast majority of the Gate District at the time. I was at a meeting with the representatives of the other investment banks and the then CFO of the DIFC Bisher Barazi. Bisher had a voice both nasal and high pitched, kind of like beaker on the Muppets but with a severe head cold. When he became excited he seemed to be out of breath and on the verge of sneezing at the same time. At this particular meeting he was certainly excited.

We were discussing the proposed IPO of Dubai Ports World. It was being proposed that DPW execute a dual listing on the DIFX in Dubai and the LSE in London and we were hoping to convince them to do a DIFX only listing. This was going to be the biggest thing to happen in the DIFC and would prove to Sheikh Mohammed that the guys who were running the Center had not merely snookered a bunch of foreigners into renting expensive real estate but had actually created a functioning financial center. Nothing makes people nervous like scrutiny and, as we now know, the guys who ran the DIFC were not used to scrutiny. So there we were in our meeting with a nervous, and therefore excited, Bisher Barazi.

Bisher had good reason to be nervous. The international banking community had been drinking the DIFC cool-aid for over a year but so far we had little to show for it. My firm in particular, Deutsche Bank, was massively committed. We had moved aggressively into the center and has helped build much of the legal and technical infrastructure that enabled the DIFX to launch on time in September 2006. We intended to use our first mover advantage to establish a dominant position in the center. If you wanted to trade, clear or settle on the DIFX odds were that somewhere along the line you were going to have to pay us. We stood to benefit massively if the DIFC worked out and the DIFX became a major exchange. That said, at the time there was precious little business going on and we in the region were starting to have a hard time explaining to our Lords and Masters in London why we were devoting so much time and effort to the project.

I had seen this before when I worked on an exchange start up in the US. The exchange had an 80% cost advantage over its rivals and still took 18 months to gain market traction against entrenched rivals so I wasn’t too worried. The difference however was that we owned equity in that exchange and made a substantial windfall on its IPO and subsequent trade sale. The DIFC had steadfastly refused to grant us equity in the DIFX which would have helped us justify the efforts we were putting forth. This being the Arab world, with its’ penchant for retaining control, we were continually told no dice. I had confidence that it would work out eventually but it was getting hard for me to keep co-opting the folks back in London and the other DB support centers to continue to pour resources into the project.

So as nervous as Bisher was, it was pretty frustrating to have him pace back and forth and harangue us in his high pitched squeaky voice about all the work that was going to have to get done in order for the DPW IPO to come to the DIFX and for it to come off without a hitch. We need a retail offering, we need DMA access to Europe, we need... we need... as he got more excited he spent more and more time looking at me and his tone switched from “we need to..” to “you need to..” “You need to connect us to Saudi, you need to provide connections to the exchange for UAE brokers, you need to...” I had already been thinking of all the things I was going to have to do to muster the resources within DB to do all these things. I would have to call in favors, I would have to fly to Amsterdam to rally the troops in GTB, I’d have to go through multiple New Product Approval procedures and I would have to go all over the firm making presentations about the bright future of DB in the MENA region. I had practically emptied my account and would now have to blow my own personal credit bubble at the DB favour bank.

Then all at once it hit me that it was entirely possible that all this would be for nothing and I would be holding the bag. So I interrupted the lecture, pointed accusingly at Bisher and said, “Listen here, I don’t work for the DIFC. I’d like nothing more than to build out this infrastructure but you have denied us the opportunity to take equity in the DIFX or any other upside in the success of the DIFC. Nonetheless you continue to demand millions of dollars in infrastructure investment and millions more in free consulting. You have to understand that I work for the shareholders of Deutsche Bank not the DIFC stakeholders and it’s going to be the DB shareholders who decide whether this gets done, not you.” (I really did say that, I was a great believer in the cult of the shareholders)

I’ll admit, I felt pretty clever. I thought that this might open the door a crack and make them cough up some equity in the DIFX so we could really see some upside when the rest of the world joined us in drinking the DIFC cool-ade. Not for the last time in the region did it turn out that I thought myself a good deal cleverer than I was, for Bisher Barazi had a plan.

Unbeknownst to me, DIFCI and my management at Deutsche Bank had been in negotiations for DIFCI to become a massive shareholder of Deutsche Bank. By June of 2007 they had acquired 2.2% of the company and became our fifth largest shareholder. And let me tell you, as far as the DIFX was concerned, Bisher’s plan worked like a charm. No more wisecracking from Ken Monahan about how the DB shareholders would decide the fate of the DIFC, the DIFC was the shareholder. It was worse than that. I had to give Bisher my cell phone number. And whenever it rang no matter the time zone or circumstances in which I found myself I would have to answer it. For the next six months at random I would get phone calls from Bisher demanding status updates, did I do this, did I do that, was it really possible that we would deliver on time and in full? Did I understand how important this was? Where was I? What was I doing? Why was I doing whatever I was doing instead of working on this? Mercifully he did not call all that often but when he did, it was not awesome.

And wherever I was at whatever time and however sober I had to reassure Bisher in as soothing a voice as I could muster that indeed at this very hour an army of people in London, Amsterdam, Dubai, Hong Kong and Bangalore were working night and day to ensure that we delivered on time and in full. And we did. We executed, with a single listing on the DIFX, the largest IPO in the history of the GCC with a simultaneous retail offer in the UAE and an international book build. We created a link to Euroclear so that international investors could buy the shares in their existing accounts and we connected clients in dozens of countries to the DIFX all over DB infrastructure. Yep, as far as the DP World IPO went, the DB investment was a stroke of genius.

Yep, a stroke of genius except for one small detail. DIFCI completed its’ purchase of DB shares in June of 2007, the all time high for the stock. At the time of the announcement the stake was worth $1.8 billion. Then fate took a hand and the financial crisis got underway decimating the values of financial institutions the world over, even companies like DB which took no government money. Today DIFCI’s $1.8 billion investment is worth $720 million and $1.1 billion has been sacrificed to the trading gods. So while from the tactical perspective it was a stroke of genius, from a strategic investment perspective it was a complete fiasco. Add to this the $2 billion loss that Bourse Dubai took on its NASDAQ and LSE shares, a transaction on which the DIFC advised, and it doesn’t look like the guys doing the investing in financial services firms did Dubai any favors. I’ll bet they wish they just let us invest in the DIFX like we asked.

This brings us back to the present, there’s nothing like losing a cool 3 billion of Sheikh Mohammed’s money, or rather money Sheikh Mohammed has borrowed, to put you in the crosshairs of the UAE and the DIFC legal systems. Perhaps Sheikh Mohammed cannot imagine that so much money could disappear without some kind of malfeasance. After all it did take outright theft in order for $165 million to vanish from Damas, surely $3 billion can’t vanish without some fancy footwork by some light fingered subordinates. From my perspective $3 billion did get lost but it got lost the old fashioned way, bad decision making, not fraud.

But there’s a difference between robbing a bunch of international investors and legitimately losing a bunch of Sheikh Mohammed’s money. If you’re an international shareholder you’re forced to rely on the law which is why you get nothing but laughter and forgetting from the Brothers Abdullah. Sheikh Mohammed IS the law so no matter how legitimate your poor decision making if you lose his money you are in serious trouble. No laughter. No forgetting. He doesn't have to rely on the DFSA, he can just throw you in jail until you pay him what he thinks you owe. Don't like it? Too bad. You mess with the bull you get the horns. This is no longer about $544,000 in back pay for Bisher Barazi, it is about Sheikh Mohammed getting some payback. Bisher Barazi had better call up that guy with the submarines and leave town because he is going to get a lot more than $122,000 in emotional damage from Sheikh Mohammed.

How the DIFIC Counter-Claim against Bisher Barazi could drag Dubai back into the debt morass from which it most recently emerged.

2010-07-21T14:27:00.000-07:00

So I have decided to have a closer look at the “Fraud Sweep” going on in the DIFC. I’ve written once already on the Dr. Omar aspect which, despite his payoff and release, remains an open question. It will actually be difficult to assess where the Dr. O case is because it is going on in Dubai Courts to the extent that it is being done within a legal system at all.

Then there is the drama of Bisher Barazi. It’s being played out in the DIFC courts with and unusual level of transparency. Both Bisher’s complaint and the response of the DIFCI are viewable by the public. Just go to the DIFC Courts website and click on “anonymous login,” search DIFIC, double click on the case and the documents come right up. They make for interesting reading.

I think Barazi’s complaint is kind of funny. Once Dr. O had been thrown out the new sheriff in town decided to clean house and basically told Barazi to go home. Barazi says that when the DIFCI told him to pack his things they said they were acting on the orders of the Financial Control Department, the organization looking into what happened to all the money that has gone missing from DIFCI. Barazi considered himself to have been terminated and according to his contract he had three months paid leave coming to him. The DIFC didn’t pay him. The new governor told him he would look into it. Nothing happened. He spoke with the guys from Finance Control and they told him he was not under investigation and that they had not ordered his suspension. He had a meeting with the governor and was told that he had no rights and if he wanted anything he should go to court. This he has done and he is suing DIFIC for $484,000 including $122,000 for “emotional damage.”

It seems to me that the new Governor of the DIFC quite reasonably wanted Barazi out once Dr. O had gone and told him to get lost. For some reason the guy decided to claim that it wasn’t his idea but that of the Finance Control department. My guess is that this is a simple administrative error. When they got rid of Barazi, nobody called HR to figure out precisely what Barazi’s contract said and he’s trying to take advantage of that for a few hundred thousand on what he surely thinks will be his way out of Dubai. Well, given the DIFCI counter-claim he’s getting more than he bargained for.

As humorous as Bisher’s complaint is the response from the DIFCI is absolutely hilarious. They begin by nitpicking when Bisher started at the DIFC, when he transferred over to DIFCI, that his 150,000 AED/month compensation was actually 90,000 in salary and 60,000 in housing allowance. Then in a bit of he said/she said they deny that the DIFIC ever told Bisher to leave the office.

This is where it starts getting bizarre and deadly serious.

DIFIC claims it did not order Barazi to leave. So if the DIFIC did not tell Barazi to leave, who did? Well, says DIFCI, the Dubai Government Audit Team. Oh, OK, and what evidence do they present for this version of events? A newspaper clipping about Dr. Omar. Yep, it's true, they present a few lines from an article in Gulf Business saying that Dr. Omar has been arrested and released pending charges of financial irregularities. Surely if the Dubai Government Audit Team ordered the suspension of Mr. Barazi there must be better documentation o this fact than a newspaper article that not only doesn’t mention Mr. Barazi by name it doesn’t name anyone but Dr. Omar. Call me crazy but I would think that the Dubai Government Audit Team would have better records than that I mean, they are an audit team after all.

Then they claim that Bisher tried to resign and they did not accept his resignation but rather placed him on “investigation leave.” What evidence is there of this? None is provided. They do say that “Although the claimant contends that the defendant has failed to provide any evidence of instruction from the Audit Department, the Claimant has in fact admitted that he was aware of the investigations.” How Barazi’s awareness of the investigation constitutes notification that he has been placed on “investigative leave” I have no idea. Sitting here in the New York Public Library, I too am aware of the investigations but I am not aware of having been placed on investigative leave. Surely the easiest way to prove the existence of instructions from the Audit Committee to place Barazi on administrative leave would be to provide a copy of those instructions. The fact that the DIFCI cannot do this actually proves Barazi’s point, not theirs.

Then come the serious allegations. DIFCI says that once it became aware of the Audit Team’s investigation it retained KPMG to conduct an independent review of the actions of the former managers of DIFCI. They claim that Mr. Barazi “breached his fiduciary duty and conducted himself in ways which would warrant his termination” it describes these things as “fraud, dishonesty, misrepresentation, and breach of trust.” Serious indeed. So what precisely does DIFCI accuse Barazi of?

Procurement of an Unlawful Bonus

This crime will be familiar to anyone paying attention to the Dr. Omar saga. DIFIC claims that Bisher and Dr. Omar conspired to pay themselves $1.2 million and $3.3 million respectively in “investment bonuses.” Then comes the zinger “The Claimant justified the Investment Bonuses by misrepresenting that DIFCI had realized an income of $60,000,000 in the 2007 financial year but deliberately failed to disclose that financial statements showed that DIFCI suffered a net loss of $80,000,000 over the same period.” At first glance this looks pretty damning and if Barazi cooked the books he should go to prison full stop. But that’s not what they accuse him of, indeed they're using his uncooked books as evidence against him. They accuse him of using realized income to justify a bonus when the net position of the firm was negative. It’s entirely possible for them to have realized a $60 million gain on a transaction while the book of open positions was down $140 million.

Then there’s the question of to whom were they making this misrepresentation? It seems from the counter-claim that the only person required to approve Barazi’s bonus was Barazi. If that is the case then who is to say ex post facto what was a reasonable level of compensation. At the time DIFCI had literally multiple billions of dollars invested. $80 million on the total value of the assets he was managing was not a material number. Paying someone $1.3 million for managing a multi-billion dollar fund, even if it has a marginal loss, as DIFCI did in 2007 is not a big number. The guys running the DIFCI today have decided ex-post facto that this was unlawful but at the time it was awarded it seems to not in fact have broken any laws. Barazi was operating in a system where there was no external review of his compensation. Given the amounts he was investing you could argue he was not taking full advantage of his capacity to pay himself. The people who set up this system in which Barazi and Dr. Omar operated sure as hell breached their fiduciary obligations to Dubai however.

Unauthorized Loans

Apparently Barazi applied for and received some personal loans from DIFCI after the board declared a moratorium on personal loans to employees. Dr. Omar approved the loans and there seems to have been no objection from the Board. They don’t claim that Dr. Omar was not authorized to approve the loans and if he was then the loans were legal. It may have been in poor taste for Barazi to ask for something that had been banned by the board but if it was within the power of Dr. Omar to grant them then I don’t see how this constitutes fraud.

Then there’s my favourite:

Failure to Conduct Due Diligence

Apparently in September 2009 as the Dubai real estate market was in free fall Barazi decided to buy $1 billion worth of off plan real estate in the Dubai Pearl development for DIFCI. He decided this on September 28, 2009. On October 5th, he sent a check for the first instalment to the Al Fahim Group and on the same day sent a letter to E&Y requesting due diligence. Thus clearly the due diligence could not have been completed before the transaction was executed. AH-HA! Caught red handed! He bought off plan real estate without conducting proper due diligence! Clearly a breach of his fiduciary duty! Given the fact that Dubai was weeks away from seeking a debt moratorium on account of a collapsing real estate market Barazi was almost certainly under a massive amount of political pressure to use DIFCI funds to shore up the market. But this is not why I think that Dubai should give Bisher Barazi a pass on this one. I think they should do it in the national interest of Dubai.

I think this for two reasons: 1.) if the Dubai Authorities are going to prosecute everyone who bought off plan real estate in Dubai without conducting proper due diligence for fraud there will be no one left to pay the subsequent instalments and the rents. Buying off plan real estate in Dubai without conducting due diligence is the national pastime of Dubai. Once the police had finished carting everyone to jail Dubai would need to hire the Saudi police force to throw the Dubai police force in jail for the same crime, and then they would have to find some other police force to throw the Saudi police force in jail for also buying off plan real estate without conducting due diligence. One may as well criminialize speeding or claiming that the reason you are late is because of the traffic, it would be an exercise in futility.

Reason number 2.) is that Nakheel and with it Dubai World have no chance of ever paying back their creditors unless a whole hell of a lot more people buy off plan real estate without conducting due diligence. The last thing Dubai wants is someone actually taking a look at the physical site of Dubai Waterfront rather than the architectural models. Someone might realize that the Crescent Shaped Islands which are valued on the balance sheet at a billion AED do not actually exist. No, no, the last thing on Earth Dubai should be doing is criminalizing the purchase of off plan real estate without conducting due diligence. Hell they should be giving out prizes for it, or allowing people to set their own bonuses as long as they invest some of the proceeds in off plan real estate for which they have not conducted proper due diligence. Now there's an idea...

In my next post I'll tell you the real reason Bisher and Dr. O are in for it.

ESCA Gives Aabar Shareholders a ham sandwich.

2010-07-18T16:25:00.000-07:00

I once walked into a classroom in college and was startled by something written on the board. Someone from the last class had written the following elegant proof (apologies to the Shariah compliant, I'm trying to be true to the facts):

Nothing is better than happiness
A ham sandwich is better than nothing
A ham sandwich is better than happiness
QED

I’d like to offer my own proof for in honor of the ESCA decision on the IPIC de-listing.

Nothing is better than the rule of law
Half a Dirham is better than nothing
Half a Dirham is better than the rule of law.
QED.

What I mean by this is that while 1.95AED is certainly a better price than 1.45AED the shareholders have no say in the decision either way. Whether IPIC or ESCA decide the price it is still a take it or leave it deal for the shareholders and they have no choice but to accept what is, in the end, an arbitrary decision which differs only who is making it and at what level. The wishes of the minority shareholders themselves are never taken into consideration. You have to remember the context, 1.45 AED is 50% of book, 1.95 AED is still only 67% of book. Usually holding companies like Aabar trade at about 1 times book in other markets. KKR for example is trading just under 1 times book as of Friday. Even though the shareholders are getting a better deal than the one IPIC offered them, it’s still not a great deal.

I could make the counter-argument against myself that the market had never priced Aabar at 1x book beforehand which may well be what has spurred this in the first place. I could do that, but then I would also be compelled to make the counter-counter argument that because under the UAE/ESCA regime it was always possible that the minority shareholders would be arbitrarily stripped of their value (as they have been) and so the shares should trade at a discount (which they did.) But this soon becomes kind of a circular argument, a sort of Inception style dream within a dream.

So this outcome is not ideal but I must say that it is a step in the right direction. A strong step. I would have bet a substantial sum that ESCA would have validated the IPIC price and actually, given the trading history of Aabar notwithstanding the book value, I would say the 1.95 price is aggressive. This is unequivocally good for the shareholders but I think it goes a bit far to declare this a “milestone for investors rights.” The investors were never consulted and therefore could not exercise their rights nor do they have a forum within which to express their views. The decision of ESCA, while a good one, was still arbitrary and therefore investors in other companies can take limited comfort from it. What is necessary is for ESCA to promulgate rules as to how minority shareholders should be treated in the future and under what circumstances, if any, the shareholders can contest actions against their interests by the majority shareholders. ESCA has announced that it is working on a large number of new rules which it hopes will further refine the markets. If ESCA can succeed in empowering the shareholders to secure for themselves the justice they have just been granted by ESCA fiat, then that will indeed be a milestone for investor rights.

Given my obsession with the Damas Heist I can’t help but think of the outcome for Aabar shareholders vs. the outcome for Damas shareholders (a fate which seems sure to spread to the creditors as well.) My nitpicking notwithstanding, the domestic regulator has done a massively superior job of looking out for shareholder rights than has the regulator operating according to “international standards” over in the DIFC. I think ESCA should use its jurisdiction over the DFM which is now the owner of NASDAQ to bring the kind of justice to Damas that they have just brought to IPIC. At the very least the entire staff of the DFSA should resign in shame. The organization is clearly unnecessary as ESCA can obviously do a better job.

Aabar gets a take-under. Shareholders get under-taker.

2010-07-12T20:03:00.000-07:00

Aabar which earlier in the year had attempted to execute a take-under of Arabtec the Dubai based construction firm at a discount to the prevailing price has done itself one better, it is taking itself private 1.45 AED per share. That’s down about 15% from the pre-delisting announcement and about 25% below the high for the past year. Those guys over at Aabar are some smart folks. Not only do they get to take their company private so there won’t be any more of these pesky disclosures as to what the investment arm of IPIC is doing but the valuation they are granting themselves is also 50% of book value. Nice trade.

Most of what I have read in the press makes no sense. There was something about how the shareholders though they might get taken out at the conversion price implied by the bonds that were issued in May. There is NO reason to think that, the conversion price in a mandatory convert is not designed to give a valuation but to imply upside. There has been some talk of ESCA demanding an independent valuation. That would shock me because clearly the IPIC guys have more power than the ESCA guys and whoever was hired to do the “independent valuation” would have a lot to gain from future business from IPIC and little to gain from the gratitude of the minority shareholders.

So what do the minority shareholders have to say about this? We’ll never know. Aabar asked ESCA to allow it to delay the meeting to discuss the delisting to August 8th, from July 27th. ESCA granted the request the same day. Given that the offer expires on August 1st the offer will have ended by the time the meeting is held. Well done Aabar, no need to discuss the merits of the offer at the meeting because anyone who takes it will of course no longer be a shareholder and therefore won’t be there. Aabar may well be addressing an empty room, quiet (rightly) as a tomb. Aabar has once again made an “O plato, o plomo” (lead or silver) offer, this time to its’ own shareholders.

The easy journalistic tack to take with this, and the one which is my natural inclination as a lazy amateur journalist, is to affect righteous indignation at the treatment of the Aabar shareholders. After all they thought they were investing alongside Abu Dhabi, the most prestigious of the Emirates, in an SWF type vehicle and instead they get a take it or leave it offer for 50% of book at multi-year lows. It doesn’t seem fair.

Well, in economic terms it’s not fair but markets have no obligation to properly value things. They do have an obligation to obey their own laws and investors have an obligation to know those laws. In the Emirates of all places investors have no excuses to not know this because the entire body of relevant law is 24 pages long. Don’t take my word for it, read them yourself. They’re sections 2/r and 3/r on the ESCA website. If you throw in another set of rules regarding arbitration which may come into play you still come up with a body of legislation shorter than the Aabar annual report. As a person who reads US financial legislation as kind of a hobby the ESCA Rules are refreshingly brief.

While the Aabar self take-under may be unfair it is not unlawful. This is not because it complies with the law, but because there is no law. If you look though the laws you’ll find nothing on the possibility of either a takeover or a de-listing, nothing about the protection of minority rights in a tender offer nor in the event of delisting. Aabar probably feels, rightly it would seem, that the fact that the shareholders are getting anything is a bit of largesse. If the shareholders are unhappy about it they can ask ESCA for arbitration but given what you can infer from the speed with which ESCA has granted the Aabar request to postpone the meeting it would seem that they will take a narrow view of shareholder rights.

So what happens next in Abu Dhabi after what would seem to be a fait accompli is actually quite interesting. What happens now will set precedent for the UAE and also for the other GCC states which have similarly thin securities laws. Most important is that this says about the plight of foreign portfolio investors in the region who will be, by definition and by law, always be minority shareholders in the region. The best outcome would be for ESCA to demand some kind of consent from at least a majority of the affected shareholders but that also seems unlikely given that the tender expires before the shareholder meeting and ESCA explicitly authorized that change. Still, the laws are yet unwritten and the precedent as yet unset. It’s too late to save the Aabar shareholders but what ESCA decides will have a big impact on how willing future investors are to put their money into the GCC.

While this is not a great episode for the Abu Dhabi capital markets it does put the DIFC under an even darker cloud. While what is happening to the Aabar shareholders is not great, it’s at least because there were no laws to protect them, which they should have known. The DIFC was created in response to the weak legal and regulatory environments in the rest of the GCC. The DIFC actually has superior laws and protections for shareholders and so shareholders should expect some protection and yet it is the site of the most egregious shareholder theft yet to occur in the Emirates. The DIFC may have better laws but lacks is leadership with the courage to enforce those laws.

WallStWTF Non-Bronzed No-Prize Award goes to....

2010-07-05T19:54:00.000-07:00

So this is my first post after a month of silence in honor of the rule of law in Dubai.

Marvel Comics is one of the most innovative media companies in the world. I say this not because of the wonderful cast of characters they have come up with over the years though they are indeed wonderful. I don’t say it because of the fact that they have emerged from bankruptcy with a vengeance, finally marrying that great set of characters to the vastly more profitable medium of film though that too was a great innovation. No, I think Marvel deserves an innovation award for it’s invention of the “No-Prize.”

Occasionally there would be “continuity errors” in Marvel Comic books. A continuity error is when there is an inconsistency between several frames such as a character having a blue shirt in one frame and a green one in the next without having changed the shirt. Many comic book readers are a bit pedantic and would write in to Marvel to point out these errors. The staff at Marvel found this kind of annoying so they invented a fictional prize which they would award to people who found these inconsistencies. They called it the “No-Prize” as kind of a joke on the recipients in order to get them to lighten up. It’s just a comic book after all...

Though the “no-prize” was a non-monetary award the fact that you could be recognized for discovering errors created a deluge of mail from nit-picking readers and spurred on the creation of the “Non-Bronzed No-Prize.” The Non-bronzed No-Prize was awarded to readers who discovered a continuity error but also explained why the continuity error was not in fact a continuity error at all but could be explained away by some massively tortuous logic. For example how a freak burst of gamma radiation temporarily changing the color of a green shirt to blue for a single frame of a comic book. Or how a wrinkle in the space time continuum enabled a character who had been killed in episode 17 could be alive in episode 19 and dead again in 20 without having actually been killed a second time, that is to say it used pseudo-logic to explain away nonsense.

Recently I have discovered a fairly massive continuity error in Dubai and so I have decided to award myself a “No-Prize.” In addition to that I have decided to award a “Non-Bronzed No-Prize” as well to a respected Dubai publication! But first, let’s have a look at the continuity error that has to be explained.

Here is a schematic of the plot outline:

Chapter 1.) An enterprising man starts a jewellery company. He builds his business up substantially and passes the prosperous firm on to his sons.

Chapter 2.) His sons are aggressive. They expand the business, and engage in new financing schemes related to gold, a key input in the business. They occasionally depart from the main business though rarely successfully. Their commercial success brings social prominence in Dubai. They are active in the community and gain the confidence and favour of the Ruler.

Chapter 3.) Constrained by financing their activities with retained earnings and bank loans the brothers decide to sell shares to the public. They decide to list on the DIFX because it will enable them to curry favour with the ruler and, importantly to have their share offering priced not by ESCA, which will apply a steep discount, but by an auction process called book building which will produce a higher price. The company will remain a Dubai entity and so must remain 51% owned by Emiratis. The brothers will not lose control. So they raise cash, make the ruler happy, and keep control. Win, win, win.

Chapter 4.) The brothers decide that their company is worth a billion dollars. This is where things start to go wrong. At that price there are not enough investors willing to bite. The demand is so low that the brothers won’t be able to place enough shares to qualify for an offering on the exchange.

Unwilling to contemplate the idea of a lower valuation or the prospect of forgoing access to external cash the Brothers rig the auction. They take company funds and invest them in a Dubai Holding VC fund called Dubai Ventures. Dubai Ventures then submits a bid with the companies own money for shares in the IPO creating the illusion that there is enough demand at the higher price to justify it and to qualify for the offering.

This goes on undetected or at least undisclosed by the regulator and the underwriter. IPO goes ahead, raising $165 million in cash for the company from international investors.

Chapter 5.) In short order the brothers transfer to themselves the money that had been invested in the company. They do this via cash transfers, the purchase of assets in the name of the brothers with company funds and the requisition of two tons of gold from the company by the brothers. The Board of Directors, which had been hand-picked by the brothers took no action to prevent this and in some cases actually approved it.

Chapter 6.) Around the time of the Dubai World crisis, the transfers to the brothers were revealed and described as “unauthorized transactions.” One of the brothers is forced to resign as CEO though another brother takes over as MD. The disappearance of $165 million into illiquid assets not actually owned by the company combined with weakening business conditions force the company into negotiations with creditors. The board of directors appoints some accountants to conduct an investigation into the “unauthorized transactions.” The authorities declare that they are “monitoring the situation.” The markets laugh and destroy the stock.

Chapter 7.) Before the audit is complete or the authorities take action the brothers negotiate a deal among themselves, one brother representing the brothers, another representing the company. They agree to repay the money within 18 months or they will forfeit their shares which are now worth only a fraction of the amounts they have stolen. Neither the shareholders nor the authorities are consulted.

Chapter 8.) The Avenging Angel of the DFSA, Steve Glynn, issues an “enforceable undertaking.” In it he outlines the means by which the Abdullah Brothers looted the company with the acquiescence of the board. He dissolves the board and bars the Abdullah Brothers from the DIFC. He ratifies the repayment agreement the Abdullah brothers have with the company and gives it the force of law, indeed he demands that the Abdullah Brothers detail their assets and grant the DFSA a lien in event of default. Finally he fines the Abdullah Brothers $3 million though suspends $2.7 million of it lest they be put into default immediately before they can do anything to rescue the long suffering shareholders.

Chapter 9.) The Abdullah Brothers fail to make their first payment of $55 million. Shareholders and the DFSA are shocked to discover that failure to pay $55 million does not constitute an event of default. It’s not possible to know precisely why because Steve Glynn relied on the agreement the brothers negotiated among themselves and is “confidential.” That is it is a secret both to the shareholders who are nominally a party to it and also to the regulators who are responsible for enforcing it. If missing a payment for $55 million does not constitute an event of default it must be a very interesting document indeed one wonders what does constitute and event of default.

Chapter 10.) The Abdullah Brothers are appointed as Senior Advisors to the company.

So this is where I award myself a “No-Prize.”

This is a country that identified a team of Mossad assassins and within 24 hours had their passport photos all over the world. Surely these sleuths should be donning ski masks and jack boots and be battering in the doors of the Abdullah Brothers, shaking them out of bed and searching their villas for the missing tons of gold. Surely there should be a massive auction in which all their assets are blown out including their four yachts and their substantial real estate portfolio. If there are a lot of encumberances so be it. Put the Brothers into insolvency and pay the creditors off as best you can, give the shareholders whatever is left and the strip the brothers of the remainder of their equity.

This is what should be happening. Ski masks and jackboots aside this is precisely what the laws of the DIFC and the enforceable undertaking of the DFSA would indicate are required by law. Instead the brothers are not only free men but back involved in the management of their own company. In logical terms this makes absolutely no sense and so therefore I’m calling it a “continuity error.”

This leads me to the “Non-Bronzed No-Prize.” The explanation for why this continuity error is in fact not a continuity error at all goes to Damas itself for its press release and to Arabian Business for printing it.

“At a time when Damas is going through a period of transition and pursuing a renewed strategy for its sustainable growth, the involvement of the Abdullah brothers in an advisory capacity provides us significant depth of knowledge and insight. In their roles, even though the involvement is strictly non executive, the company will benefit from their valuable advice on the unique aspects of the jewellery trade."

This is great stuff. Damas is going through a “period of transition.” Periods like this have a name: insolvency. They are “pursuing a renewed strategy” for “sustainable growth” for which the Abdullah Brothers “provide significant depth of knowledge and insight.” Presumably this new strategy is to destroy the bondholders and trade creditors. Who better to advise them on this strategy than the very men who destroyed the shareholders? I have no doubt anyone able to steal two metric tons of gold will be able to provide “valuable advice on unique aspects of the jewellery trade” chiefly the portability of the collateral involved in that trade. Perhaps this should be renamed the “Non-Gold No-Prize.”

But I don’t know that I can stop there. The emerging market mutual funds who bought these shares and are not suing Damas and the underwriters into oblivion also deserve a “non-gold no-prize” though it is obvious why they are acquiescing in the continuity error. They make their money by convincing investors that they are knowledgeable about emerging markets. For them to sue to recover losses they took from having been defrauded would undermine their chief marketing tool namely the belief of their investors in their emerging market savvy. So they stand by and get robbed by the Abdullah brothers and say nothing in order not to look like the fools they are.

The deeper question is whether the DFSA is going to also garner a “Non-Gold No-Prize.” Will they be taken in by the idea that the new appointments of the Abdullah Brothers do not violate the terms of the enforceable undertaking. Do they think that the valuable advice on the unique aspects of the jewellery trade that the Abdullah brothers can provide are worth the DFSA being made completely ridiculous by the greatest thieves in the short history of the DFSA?

Deeper still is the question where the readers of this blog stand. Are comfortable that though the Abdullah brothers may have shafted thier shareholders such a thing could never happen at Emaar or Arabtec or Dana Gas or Agility or whatever company you happen to be buying shares in today....

Not to worry, I've got a whole warehouse full of Non-Bronze No-Prizes ready for the next set of unwary MENA investors....

The ECB Bond Desk Flees as the EU/IMF Rescue Package bursts into flame.

2010-05-31T13:09:00.000-07:00

Apologies for the hiatus but I have been like a deer in the headlights these past few weeks. Events have occurred in the markets and in Dubai which have absorbed my time and attention and come more swiftly than I have been able to write about them. Thus this will be a limited post about what I think is the most important thing going on in the world right now.

It seems to me that we are in the middle of an extended speculative attack on the Eurozone. I have described the mechanics of this attack in an earlier post. The initial weak point was Greece and the markets have effectively shut Greece out of the capital markets and triggered the bailout by the IMF and the EU. This obviates the need for Greece to access the capital markets for at least two years which is good news but the stresses on Greece remain. The five year CDS on Greece still indicates that the markets have severe doubts about the ability of Greece to successfully implement its austerity package without damaging the economy so much that it cannot recover.

More seriously the obvious reluctance of the EU to help Greece and the riots in Athens that accompanied the vote on the austerity package necessary to secure the aid and avoid default massively undermined market confidence in the Euro and the panic quickly spread from Greece to the Iberian peninsula. This necessitated the “nuclear option” of a much bigger package to reassure the markets that the Eurozone would not come apart. The Europeans produced this package but it has come under attack almost immediately.

I think at this point it might be helpful for me to define what I mean by "shut out of the capital markets" and a "speculative attack." By "shut out of the capital markets" I mean that when a combination of CDS demand and a reluctance on the part of investors to buy newly issued debt of a country either chokes off all borrowing or pushes the cost of borrowing up so much that the interest on the debt alone would be more than the country could bear. For example a country whose economy was growing at 3% that was forced to borrow at 15% could never escape the debt trap and so would stop borrowing. The reason this is bad is that most defict countried rely on their capacity to borrow to fund government spending. If the capital markets close for a country the government has to shut down essentially enacting overnight the kinds of austerity that Greece plans to implement over a period of years. This can result in some serious social unrest.

I really like the phrase "speculative attack" because it is descriptive of the violence with which the markets assualt fixed regimes but to the general reader it may conjure up the wrong image. I think it might conjure up a group of hedge fund managers "speculators" in wearing frock coats and twirling their waxed mustaches while in an oak panneled study somewhere in mayfair they sip sherry and plot the downfall of the countries on the European periphery. This is not what I mean. Regardless of the paranoiac dreams of Angela Merkel the calamity which is affecting Southern Europe is not the result of a plot of some evil speculators. There are in fact very good reasons not to own Iberian bonds right now that have nothing to do with human avarice.

The markets are not driven by a single person or even a coordinated group but they do have definite behavior patterns. I'm going to go out on a limb with an analogy here. Imagine the international capital markets as an inflatable above ground swimming pool with a flexible bottom. Imagine that the water in the swimming pool is all the investable capital in the world. Further imagine that instead of resting the the ground the swimming pool is being held up by a group of men standing underneath it. These men are the worlds central bankers. Ideally all the men holding up the swimming pool would be graduates of a Charles Atlas Program and the bottom of the pool would be level. But that is not the case, the Central Bankers and Treasurer holding up the bottom of the pool vary widely in strength. The weaker they are, the lower thier corner of the bottom. This corresponds to the interest rates they have to pay. Think of a speculative attack as one of the weaker Central Bankers not being able to hold up his corner of the pool very well, and as he lowers his section (raising interest rates) the water in the pool flows toward him making his burden ever heavier. A successful speculative attack occurs when virtually all the water in the pool flows to where the weakest guy is holding it up and then bursts out of the bottom. It's an imperfect analogy but you get the idea. The water does not plan what it does, it simply obeys the laws which govern it. The same is true of investment capital on a macro scale.

Whether this attack succeeds or fails will determine whether we enter a new phase in the credit crisis, a very serve one I think, or whether we shamble on towards recovery and a return to normalcy. A successful speculative attack would involve the markets succeeding in raising the cost of funding for Portugal to such an extent that, like Greece, it was forced to draw down the new EU/IMF package. Now if it did so, also like Greece, it would not have to access the capital markets for several years and therefore would be safe. In fact, Portugal’s funding needs are light enough that it might not even have to go further than the $110 billion balance of payments fund which the EU used to rescue Hungary, leaving the EU/IMF with all EUR 750 billion of their ammunition. The problem would be that once the markets had beaten Portugal, they would move on to Spain.

By the time the attack on Spain began in earnest the markets would have already forced two EU members out of the public markets and would probably have gathered strength from that. If the markets succeed in shutting Spain out of the capital markets then we are in for some serious action. Spain will then have to trigger the EU/IMF funds in order to keep the government running. This will mean that all the EU members will have to go to the capital markets themselves in order to fund the project. This may be no easy task. For example, the German share of the bailout is about 5% of GDP. Given that it’s total debt to GDP ratio is already 80% Germany itself will, after the bailout, have a dangerously high debt to GDP ratio. This is the dark side of the bailout, it blurs the balance sheets of the European governments and makes a speculative attack on Germany a possibility. If that happens, it’s game over.

So right now the most important thing to watch is the Portugese CDS. A lot of people are watching the Euro as a proxy for this but I don’t think its appropriate because ultimately the level of the Euro will have little effect on the availability of capital for Portugal which is the true catalyst for Armageddon. If the markets can push the Portugese CDS over 750 then I think it’s only a matter of time before the gig is up. So if the Portugese CDS is the canary in the mineshaft for Armageddon when will we know that it’s safe to go back in the water? Sadly this is a much harder question to answer and is why I think any rally from this point in world equity markets is likely to be subdued. There is no obvious thing that would make the Portugese problem dissipate. Even if the Portugese CDS comes in the most likely outcome will be further political wrangling within Portugal as to who should bear the costs of austerity and this will likely push the CDS back up.

Personally I think the most likely outcome is that Portugal muddles through, it’s true that it’s in bad shape but it is nowhere near the position in which Greece found itself. It seems also to have learned the lesson of Greece and is actually taking tough measures to bring its deficit under control. Of course if that happens then equity markets will begin to react more to the strong data that has come out of the US and the fact that all this madness means that Bernanke is even less likely to take his foot off the gas. Thus if Portugal calms down enough, there could be a big rally. That said, Iberia is not out of the woods yet and is still very vulnerable to a general flight from risk assets that might be caused by something unrelated to its own finances such as tensions on the Korean peninsula. This thing is not over by a good long way. The only certain thing is that we face significant uncertainty.

FREE DR. OMAR

2010-05-16T20:40:00.000-07:00

I have to begin this article by saying that I have no love for Dr. Omar bin Suleiman the former governor of the DIFC. The photo above was taken at the moment of the DIFX launch on September 26th, 2005. Pictured are the Governor, the CEO and the Chairman of the exchange touching the magic globes which launched the exchange. What you can’t see in the photo is me in the back of that room. I’m there with cell phone ear pieces in each ear communicating with my trading desk and with that of another firm engineering what would become the first trade on the exchange. It was kind of like the Wizard of Oz. There was Dr. Omar the Great and Powerful and I and my colleagues were the men behind the curtain. It was as a man behind the curtain that I got to know Dr. Omar.

Not that Dr. Omar would have any idea who I am. The few times I met Dr. Omar he gave me a handshake and a cold smile which said “kindly disintegrate” as if someone had obliged him to shake hands with a garbage man at the end of a long day of work. Dr. Omar had no desire whatsoever to shake the hands of the people who were actually doing the work that was keeping him in the spotlight. That’s what we were paid to do, we should get on with it. He has a point there. But I think it we also made him a little uneasy. The reason for this was that those of us down in the engine room of the DIFC Technocracy had much insight into what Dr. Omar was, and what he was not.

What he was, was a seducer.

Yes, Dr. Omar was a hit with the ladies, the stories of his hijinx made the rounds of the DIFC. I’m sure they were enhanced with the retelling, but the grains of truth from which they grew however are pretty believable. After all, it’s not difficult to be a success with the ladies when you can decide your own compensation and, in Dubai, the ladies take cash. As interesting as that is, far more important than cutting a swath through Dubai and Moscow’s female populations was the ease with which he penetrated the very masculine world of The City of London.

Dr. Omar’s gilded tongue lured virtually the entire London banking community to Dubai and enabled it to eclipse Bahrain as the regions financial center. It was not a hard sell. Oil was on its way from $50 a barrel to over $150. Most of that money was going to Saudi Arabia and a fair amount to Kuwait, Qatar, and Abu Dhabi. These people were piling up money faster than even the Chinese. They were going to be in desperate need of some serious banking. Who better to do it than the London Banking community? But who wanted to live in those crazy places? Surely not Londoners.

What about the DIFC in Dubai? Well, in Dubai you have nightclubs which have liquor in them as well as a healthy complement of young ladies from Eastern Europe and Southeast Asia. Heck, it’s practically the East End. And what is this DIFC business anyway? Oh, it’s a legal zone with UK Law as opposed to Sharia? Now that’s an even easier sell. What’s that? Zero percent tax for the next 50 years? Outstanding! Our non-US nationals can relocate there and pay zero percent tax (Sorry Americans, you’re globally taxed. The war on terror is not going to pay for itself as it turns out.) Wow, the DIFC/Dubai is like The City, plus the East End, times the reciprocal of your tax rate!! Sign me up Dr. O. And just like that Dr. O built the DIFC into what is: the largest concentration of international financial expertise in the Middle East. By miles. As a seducer Dr. Omar did his job well and in spades.

What Omar was not was a technocrat.

He’s described this way in both the local and the international press. The story seems to be that during the crisis Sheikh Mohammed removed the “technocrats” to replace them with “loyalists.” Dr. Omar was neither of these. Dr. Omar may be guilty of having expensive tastes in cars. He may be guilty of some spectacularly poor investments. He may be guilty of being a bit haughty toward us unter-menschen down in the DIFC engine room. But, and I can say this from my interactions with him and his staff, he was totally innocent of any knowledge whatsoever of what it would take to make the DIFC a successful center other than as a real estate venture to which he was able to lure international banks as tenants.

He did not concern himself with the minutia of what precisely was necessary for the credibility of the legal system. He did not busy himself with what it would take to ensure the success of the DIFX or how it should interact with other exchanges in Dubai or the region. He also did not consider the possibility of locking in the commitment of the international banks to either the center or the DIFX by parting with equity in them. Rather he had the DIFC take a large equity position in one of the main supporters of the DIFC. This and other investments that Dr. Omar made ultimately came to grief to the great embarrassment of himself and Dubai.

I don't blame him for any of this. He did not have to be a technocrat because he lured acutal technocrats such as myself to the center and we did the boring job of haggling over the Personal Property Law and the DIFX exchange rules. He did what Dubai wanted which was rent real estate to banks so that other Emiratis could rent apartments to bankers.

But was he a criminal?

As I write this Dr. Omar is languishing in jail in Dubai. He has been arrested on the charge that he appropriated public funds for his own use. In their article the Abu Dhabi newspaper The National says that he disguised this misappropriation as “annual performance bonuses.” I’m troubled by this for several reasons. First of all it was not a big secret that Dr. Omar was paying himself a kings ransom for doing his work in the DIFC. I’ve written an earlier article on this and my chief source was an article that was published in Bloomberg in 2005 about Dr. Omar’s Ferrari collection. If you are secretly engaged in embezzling from the state and disguising your income you don't give interviews to Bloomberg about how you're taking delivery of your second Ferrari.

Second Dr. Omar worked for the state. Therefore any funds derived from his work were therefore “state funds.” It seems to me that “annual performance bonuses” that you spend on yourself are not therefore “misappropriations” they’re “appropriations.” You’re supposed to spend your bonus on yourself. That’s what it’s there for. You can’t criminalize something simply by putting quotation marks around it. If he spent a bunch of money on himself personally and called it “real estate investments” or he pulled an Abdullah Brothers and engaged in some “unauthorized transactions” then I could see it. But it seems to me that the transactions that Dr. Omar engaged in were all “authorized” if not entirely successful. The question to ask is “Did Dr. Omar put Dubai on the map as a financial center in the Gulf?” Yes he did. Is it reasonable to believe that Dubai would pay him based on his performance which was a success? Sure as you’re born.

So one of two things must be true: either Dr. Omar paid himself performance bonuses which were approved by people higher up in the Dubai hierarchy in which case they should be faulted not him, or there was no oversight of the DIFC compensation regime whatsoever in which case Dr. Omar was perfectly justified in paying himself whatever he saw fit and if Dubai is unhappy with this they have no one to blame but themselves. In either case, Dr. Omar should not be in prison. Unless there is something the Dubai authorities are not telling us about the deeds of Dr. Omar he should be freed.

I think the more likely explanation is that Dr. Omar’s investments lost a ton of money and he may not have fully understood some of the more complicated transactions into which he entered. He therefore may have not been totally candid with the Ruler with regard to the financial position in which the DIFC found itself. This is bad but if it is a crime there are any number of other people in Dubai who should be standing tall before the man. Chief among them Sultan Ahmed bin Sulayem the Chairman of Dubai World and the former Chairman of Nakheel who has set his son up in business with the creditors funds only to spin him out with no compensation, obliterated tens of billions of dollars of investor funds, and given Dubai it’s largest black eye so far.

But I am not advocating jail time for either Dr. O or bin Sulayem. Dubai has serious governance issues but this is more a lack of oversight than criminal activities on the part of the managers. In order to recover Dubai needs risk takers and entrepreneurs who operate within a predictable and well governed system. Throwing people in prison for overpaying themselves for doing what you asked them to do and using powers that you gave them is not the way forward. The way forward is to make it clear to the people who are the Stewards of Dubai in what incentive structure they operate then let them go without having to fear prison in the event that Dubai changes its mind. It would be an important step for Dubai to either better explain why Dr. Omar is in prison, or to free him.

Though I dislike him both personally and professionally I suggest the latter.

The ECB Bond Desk plans it's next moves...

2010-05-12T10:39:00.000-07:00

Ok, so the markets have had a few days to digest the EU’s newly erected defences against the speculative attack on the Euro that has been launched. What has happened?

On Monday the Euro popped, sovereign CDS spreads tightened a lot indicating that the risks of sovereign default had lessened substantially, and finally the European equity markets screamed higher and took the rest of the world with them though not as aggressively. Yesterday the Euro sold off and the European equities markets came off their highs but the sovereign credit markets continued to tighten. Today the Euro is a little higher but still near the lows, the equity markets are catching a bid on some good earnings news, and the credit spreads continue to come in.

So what does all this mean?

The EU has won a tactical victory and regained the initiative but is still in very serious trouble at the theatre and strategic levels. The delivery of the EU-IMF package to Greece combined with the outright purchase of Spanish and Portuguese bonds by the ECB has blunted the immediate speculative attack its’ main routes of contagion. It is true that this has not brought a bid to the Euro but the proper way to judge the success of this program is through the sovereign CDS markets all of which have tightened every day regardless of the direction of the Euro or the equity markets. One could even consider that the declines in the Euro are an expression of confidence that the ECB bond purchase program will be robust enough to function as quantitative easing despite the ECB pledges to withdraw liquidity elsewhere.

This tactical success has enabled the EU to regain the initiative and will buy time for the EU governments to pass the remainder of the package. The main problem is that neither the package nor the bond purchases address the intermediate or strategic issues which plague the EU. The theory is that the existence of a EUR 750 billion fund for the stabilization of the government finances of the weaker countries will deter any other speculative attacks on the EU. For the time being this seems to be working.

At the intermediate level there remain two very serious problems. The first is that the economies of Southern Europe remain weak and globally uncompetitive. Think about how freaked out Americans are about the rise of Chinese manufacturing and Indian service outsourcing. The marginal productivity of an American worker is almost 1.5 times that of a Spanish worker and more than twice that of a Portuguese worker. If Americans are in trouble, Iberians are doomed. Keep in mind that the governments are all committed to austerity measures to reduce their budget deficits even if the stabilization facilities are not draw upon. In all these countries the government share of GDP is 40%, if you embark on a massive program of reducing that, you are going to harm the non-government sector as well. All these countries have serious recessions on the way.

The second problem they have is that there does not seem to be a political consensus in these countries that the austerity measures are even necessary. The Eurozone as a whole had a near death experience this weekend and the Greek unions are already calling for more strikes. I can imagine that the Spanish and the Portuguese unions may feel the same when the time comes for their salaries and pensions to be on the block. I think the mere existence of the EU rescue package will exacerbate these tensions. Since the worst possible outcome now is not bankruptcy but a drawdown of the EU facility the unions have even less reason to compromise. They should basically press the government for a slightly better deal than they would get under the EU conditions but they have a lot more room to play chicken because they know that in the worst case scenario they don’t have to ask the markets for funds, they have to ask the EU which has already promised them.

The EU governments are hoping that the existence of the EUR 750 package means that it is unlikely to be used. I think the opposite is true, its existence guarantees that there will be more resistance to local government austerity measures which will force its deployment. Once that happens the balance sheets of the governments of Southern and Northern Europe will be linked and then the speculative attack will move North. Then the crisis of willpower will be not that of the Spaniards to take wage cuts but of the German taxpayers to finance them. This will be an even harder test, and the markets know that.

The photo at the top of this was taken during the battle of Kursk, this was an attempt by the German Army to encircle an extended Soviet Army in Central Russia in 1943 after the battle of Stalingrad. It was a bold and expansive plan which, if successful would have trapped and destroyed 20% of the Soviet Army and restored the initiative to the Germans. The Germans underestimated the size of forces opposite them, and had their best units chewed up in the largest tank battle in history. Afterwards the Russians were on the offensive until they reached Berlin. In the end no amount of tactical brilliance was enough to overcome the strategic dilemma the Germans had undertaken.

GIANT ABDUALLA LOCUSTS ATTACK DIFC!! SHAREHOLDERS BLED DRY!! DFSA POWERLESS TO STOP THEM!! TENANTS IGNORE MCKINSEY STUDY AND FLEE FOR THEIR LIVES!!

2010-05-10T13:31:00.000-07:00

Apologies for the tabloid headline. I’ve been wanting to use that photo for months and I just got the chance.

So while I was distracted by watching the Eurozone melt down and then today melt up I missed a very important story in Dubai. The Abdullah Brothers have missed their first payment of $55 million of the $165 million and two tons of gold they stole from their public shareholders.

If you have been reading my blog for a while I have written extensively about massive theft from the shareholders of Damas by the Abdullah Brothers. I began with a two part article about how the theft was undermining the confidence of the DIFC. I wrote a few other pieces about the ridiculousness of the fact that the Abdullah Brothers were allowed to negotiate with themselves the terms of their repayment. I begged the DFSA to do something and then I celebrated the DFSA when they did in fact take action.

Well, it might be time for a bit more action to be taken. The Abdulla Brothers were supposed to make a $55 million payment at the end of April and they have not done so. In fact from what I can gather from the various news sources they haven’t even made a partial payment. Damas put out a statement saying that the payment was missed because of the complexity involved in liquidating the assets. They also point out that under the terms of the confidential agreement between the Abdulla Brothers and Damas the missed $55 million did not constitute an event of default.

Now let me get this straight. In their Enforceable Undertaking with the Abdullah Brothers the DFSA mandated that they had to repay the money they stole from Damas according to the terms of their original agreement. At the time that agreement was written one of the Brothers was in fact the Chairman and another was the MD responsible for daily operations. The CEO was non-Emirati and so presumably had little say. Now it comes out that A.) missing a payment of $55 million does not constitute an event of default and B.) the agreement is secret?

You have got to be kidding me. The DFSA signed off on a secret agreement whereby non-payment is not an event of default? If non-payment is not an event of default what the heck is an event of default. Of course we’ll never know for sure BECAUSE THE AGREEMENT IS A SECRET! Was it a secret from the DFSA at the time they agreed for it govern the restitution to Damas? I do have to say that it was very forward thinking of the Abdullah Brothers to negotiate this agreement WITH THEMSELVES and then make it confidential.

And what is the reason for the delay? Complexity? You have to be kidding me. According to an earlier article in the National they own four boats. How complicated is it to sell a boat in Dubai? I’m pretty sure they get sold all the time. What is this about Damas “working with the Abdulla Brothers?” Why are they working with them? Why are they not simply holding a massive auction and blowing out of all the Abdullah Brothers assets to the highest bidder until they get to $165 million? How complex would that be? There’s even a company in Dubai that Damas could hire to do it. Or better yet the DFSA should be doing it.

The signatory to the Enforceable Undertaking (EU) on behalf of the DFSA is Steve Glynn. I know Steve and I think he’s a good guy. I think he should do the following. I think he should find the nearest telephone booth in the DIFC. He should enter said telephone booth as his mild mannered self and emerge as his regulatory super-hero alter ego: THE ENFORCMENT UNDERTAKER and he should enforce the enforceable undertaking.

He should make the repayment agreement a matter of public record first of all so that the poor long suffering shareholders of Damas can know what they’re in for. Then if there is in fact no circumstance in which the Abdullah Brothers can be put into default he should declare that the agreement does not meet the requirements of the Undertaking and should invoke article 17 of the Undertaking. This would enable him to declare them in default and use the remedies he has under law to enforce the lien on their assets and start auctioning them off until they get to $165 million and the shareholders are made whole. If the Abdulla brothers are bankrupted or reduced to penury by this then those are the breaks. Maybe the next guy who does an IPO on the DIFX won’t rig the book building process and then steal the proceeds.

Sometimes I really don’t understand Dubai. Here you have Dr. Omar in jail and all he did was pay himself $15 million dollars for what, at the time, seemed like a good job of attracting firms to the DIFC. These guys STEAL $165 million, more than ten times what Dr. O gave himself, from their shareholders and are walking around free men with the liberty to choose among their four yachts on which to indulge their passion for fishing all the while missing the first payment deadline imposed on them by the regulator. The Damas fraud is a bigger black eye for Dubai than Dr. Omar times a thousand.

Dubai is worried that firms are leaving the DIFC and have hired McKinsey to find a way to attract firms to the Center. I’m going to write something more in depth on this but I’ll save them a few million dollars on their McKinsey fee right here: the only advantage that Dubai has as a financial center to counter the fact that it has NO money is the idea that the DIFC has a regulatory regime which is more attractive than any of the other Gulf States.

The letter of the legal and regulatory system really IS qualitatively better for executing financial transactions than the surrounding jurisidictions. But in law as in life the letter is only as good as the spirit. By letting the Abdullah brothers make such an obvious mockery of it that I can write articles like this for months Dubai is destroying its only advantage. If you want to keep people in the DIFC don’t let favoured Emiratis rob shareholders blind and then so obviously get away with it that I can write article after article for months saying out loud what everyone in every bank is thinking.

Come on Dubai. It’s time to step up, there’s a game on here. You took the crown from Bahrain, do you have what it takes to keep it?

The Germans and the EU roll out the big guns.

2010-05-10T13:06:00.000-07:00

So it looks like the rumors I discussed on my blog last night did not go far enough. I was off both with regard to the breadth of the measures and their magnitude. I still think they are likely to be tested but it may be some time off before they are and the sheer size as well as the speed with which they were negotiated will probably make the Bond Vigilantes take a step back. It’s kind of like the EU went into the weekend as Clark Kent and then came out of it Superman.

So what are the packages?

1.) EUR 60 billion gets added to the Balance of Payments fund by all EU governments. This was a fund that was created in 2008 to help non-Eurozone countries cope with the financial crisis by extending them credit.
2.) EUR 440 billion is provided in bilateral loans and guarantees among the Eurozone countries. This package needs to be approved by the parliaments.
3.) The IMF will contribute EUR 250 billion to the enterprise.
4.) The Federal Reserve Bank of the US has extended swap lines to the European Central Banks in order to add dollar liquidity.
5.) The ECB agreed to potentially purchase government bonds. If/when they do so they will also engage in “sterilization” so that the purchases are not inflationary.

So what does it all mean?

Well the main thing is that I think the EU successfully demonstrated its resolve and its capacity to respond to a crisis of confidence. That’s the most important thing. Behind that I would say that the most important element is the ECB agreeing to buy bonds. The big numbers involved in the package are big but the money won’t even be available for a while and as I mentioned in my previous post to even get at it a government would have to agree to some stern measures so most will not ask until it is too late to do anything else. But the ECB stepping in as a buyer of last resort for the sovereign credit markets, that’s a big deal.

So what effect is it having?

Well, interestingly after a pretty big initial rally the Euro has fallen off. This should not be surprising because what the EU is really doing is making it easier for countries to run their deficits knowing that they can access these funds if they make mistakes. Think of it as creating massive moral hazard on the national level. The weaker countries in Europe now know that they are too big to fail.

The credit markets and the stock markets love it. Greek, Spanish, and Portugese CDS markets are all massively tighter. You would expect this now that the ECB is probably out there buying their bonds with both hands. European equity markets were all up HUGE and the US is up about 3.7% right now.

What’s the big picture here?

I think in the short term the EU has scared off the speculative attackers and has given some breathing room to Spain and Portugal. On the other hand they have made it harder for the political systems in those countries to compel the kinds of austerity that they’ll need to implement in order to get out of the hole they are in. It also ties the stronger economies to the weaker ones by enabling them to tap the capital markets in the name of the stronger economies. The current crisis may abate but it is sowing the seeds of the next.

German/EU Air Cover Arrives in Greece

2010-05-09T15:17:00.000-07:00

I have to be quick about this as I have to head off to mass. So the rumor is that the EU is coming up with a $500 billion package for use in the event that any other Eurozone governments get into trouble with regard to thier finances. It sounds like EUR60 billion of it is hard cash raised by the EU centrally backed by the member governments and EUR440 billion is in the form of bilateral loans and loan guarantees. There is also talk that the ECB will engage in a program of quantitative easing by buying up the EU government bonds. There is also a possibility that the EU may throw its hat in the ring and there has been talk that Fed will reinstitute its successful swap line program. Much of this is speculative and some of it (the ECB QE part) is directly counter to the last statement made by the relevant person.

Right now the markets are loving this. S&P futures are up 20 points and the Euro is up )$0.135 to $1.2891.

So is that it? Let me tell you I'd like to think so but I don't think the bond vigilantes. Are going to give up that easy. So what do we really have here? The headline number: EUR500 billion is certainly designed to impress but there has to be a lot of fine print in there and once the markets get thier hands around that they'll be probing for weaknesses.

What does a problem debtor have to do to qualify for the guarantees? What conditions are involved? Are they conditions that would likely induce the governments to put off asking for help for as long as possible? Also what kind of domestic approval is required to get this done? Given the circus in Europe this past week with regard to the IMF deal for Greece I am not filled with confidence that the voters in Europe will go for it again. If this mechanism is a gun but requires voter approval for the bullets, it's not really a usable weapon tomorrow at noon is it?

Far and away the most effective thing would be some kind of facility that would enable either the ECB or the EU to just start buying the hell out of Spanish or Portugese bonds and crush the CDS speculators and create a short squeeze there and in the Euro. I understand that there are massive issues with the ECB engaging in that kind of activity. If the EU doesn't do it then there will be continuous pressure on those bonds until the governments are forced to ask for the guarantees. Then we'll know if it worked.

The EU is trying to lead with a strong hand, trouble is, the doubters have a strong hand too. Oh, look here come the bond vigilantes now...

WE NEED TO DO THIS EVERY DAY DUDE!!!

2010-05-08T16:12:00.001-07:00

This is a bit out of the ordinary but I just listened to this thing and it’s so awesome I had to share it.

There has been a lot of talk about how the crash on Thursday was driven by electronic trading, and it was. But a lot of non-electronic trading still goes on and sometimes tells you more than a straight line down on a screen.

This is a recording of an Phone Clerk in the S&P 500 futures pit in Chicago describing the 10 minute long crash on Thursday. Given the massive reliance on machines a lot of people never hear this kind of thing anymore but it really gives you an emotional sense of what is going on. This has a personal note for me because what this guy is doing is what my first job in finance was way back 21 years ago in 1989 when I was 16. The Chicago floors have a language and culture all their own which might (pardon the pun) be Greek to the average listener so I will try to explain what the guy is doing and the language he is using.

The financial instrument which he talking about is the S&P 500 index future traded on the Chicago Mercantile Exchange. The index futures represent $250 time the value of the index and they expire every three months. Basically if you buy a future and at expiration the S&P 500 is lower you have to pay the seller $250 times the number of points lower it is on expiration day, if it’s higher the seller pays you $250 times the number of points by which it is higher. Given that the S&P closed at 1110 Friday each contract as a notional of $277,500.

The mechanics of pit trading are a bit arcane, and indeed they were invented in 1848. If you look at the photo above you can see what the pit looks like from above. In the center are the market makers, traders who provide liquidity to “paper” the big brokerage firms. They’re called “paper” because their orders used to come to the pit on paper tickets whereas market makers used cards. The way they provide liquidity is by “making markets” to the brokers. A “market” is composed of a “bid” price he is willing to pay and an “offer” or “ask” price at which he is willing to sell as well as a quantity. The traders stand in the pit and with a combination of shouting and hand signals broadcast their bids and offers to the ring of guys you can see in yellow jackets around them. Those guys are Arb Clerks. They communicate with the guys standing in the booths you can see surround the pit called. Those guys are called Phone Clerks because they are on the phones to customers telling them where the markets are. The guy in the audio file is a phone clerk telling you what is going on in the marketplace.

In order to process the massive amount of information and to avoid confusion the arb clerks use a kind of verbal shorthand. The S&P trades in ten cent increments and ordinarily they would tell you where the markets are using only the cents column, and whole points are referred to as “handles.” So if the market drops 5 points you might say “we’re down 5 handles.” So a market quote of 1115.20 bid to buy offered for sale at 1115.80 would be “20 at 80” and it would be presumed that you knew the handle was 5, the last index digit. When the market crosses a whole index point its differentiated with the term “even.” So a market 1115.80 bid offered at 1116 would be “80 bid at 6 even.” 50 cents is abbreviated as “half,” and sometimes whole numbers are designated with “the figure.” So 1118.5 bid at 1119 Might be called “eight half bid at 9 the figure.”

In addition to telling you what the markets are the phone clerk will also tell you what’s trading. This is very helpful because it tells you something about the direction. If the buyer crossed the bid offer spread to pay the offer that’s a sign that things might be going higher. So it’s very important for the phone clerk to tell you what is trading. OK, have a listen and then I’ll give you some more color.

If you don't get the above widget try this:

http://www.archive.org/details/MarketCrash-06May2010-SpPit

The conversation begins at about 1:38 in the afternoon Chicago time when the S&P 500 was trading at about 1140. At that point the market was already down over 20 points and someone must have asked him where the limit was. The CME has momentary trading halts if the S&P goes down about 10% but its a fixed number on Thursday it was 110 points. It happens so rarely people forget and the opening conversation is the Phone Clerk and another guy talking about how far away the limit is and the speaker doesn’t believe it’s all the way down at 1053. Which “90 handles, or like 1000 dow points away.” Of course this is ironic because five minutes after they have that conversation it’s a few points away.

In a few minutes a few “HUGE” paper sellers come in and sell it down 25 points in a few minutes to 1115, this is probably panic selling based on the Greek issues. Then once if goes through 1110 the figure the bids just get hit like a steam roller, 1106, 1105, 1104, 1103... crushing them when he gets down to 1070, and 1065 there are offers and no bid down to 1060. For a while it’s 1060-1070, a 10 point wide market in a product which so liquid that it normally a dime wide. That gives you a sense of how massive the uncertainty is. People don’t have any idea what the market should be worth that the bid offer spread on the most liquid US equity product is 1% wide.

To give you an idea of scale, the US market cap is about $11 trillion so each point represents about $10 billion of market cap, so as he’s rattling off the points on the way down each new lower trade represents $10 billion of destroyed value. When the markets are 10 points wide the market can’t properly value the US stock market to the nearest $100 billion.

What is interesting is how little trading actually goes on at the bottom and then how fast it comes up, the offers just start disappearing on the way up, by the time the bid comes back up to about 1090 there are no offers. At one point he talks about how this is going to “blow people out like you would not believe.” At one point he talks about how someone sold a 100 lot at 1060, by the time the tape ends four minutes later that trade would have lost $1,250,000 for whoever did it.

I have to say that the exchange floor culture is one of the coolest places to work ever. The world is melting down and this guy is so high on adrenalin he can’t get enough. My favourite phrase comes at 10:13 when he screams out “WE NEED TO DO THIS EVERY DAY DUDE!”

That’s the Chicago way.

The good news is the IMF Money Train has arrived at Athens Central Station...

2010-05-06T21:18:00.000-07:00

OK, that had to be one of the craziest days in the markets ever. So much was going on I almost don’t know where to begin.

THE PLAYERS

Think of it this way. The governments of Europe, the European Central Bank and the IMF are acting out a drama in front of three separate audiences who are responsible for judging them and who communicate with each other through price signals. These audiences are the foreign exchange, credit and equity markets. Generally a credit trader will trade only credit and or an equity trader will trade only equity so the markets have different personalities.

Generally the credit markets tend to be filled with more analytical long term thinkers than equity markets do because its’ easier to change your mind in equities. Foreign exchange is dominated by people who are actually moving money around for a commercial purpose: trade, cross border investment, that sort of thing as opposed to credit and equity markets which are investments in their own right. The foreign exchange market is by far the largest and followed by credit followed by equity.

THE DRAMA

The drama as that is being played out is how the Eurozone is going to cope with the massive fiscal deficits of the countries on its southern rim. Today there were several acts in that drama. The European Central Bank held a meeting. Spain held a bond auction. Greece voted on the austerity package.

The ECB kept rates unchanged but some people thought that they might consider some kind of monetary easing either through a cut in the rate or some kind of quantitative easing such as the Federal Reserve has done in the US. The ECB announcement and the remarks of the Chairman said the topic was not even discussed. I think their objective was to show the world that they are confident that the IMF package will work so they are not considering drastic action. There are quite a few market participants who are deeply sceptical of the efficacy of the IMF package and have thier eyes on Greece and Spain, those people were disappointed with the ECB.

The Spanish bond auction went well I thought. They had to pay a higher rate for their bonds than they did the last time they went to the market but their credit has been downgraded since then and they did have an auction the day after the riots in Greece so I think this is understandable. The bid to cover ratio, or the ratio of amount of buyers relative to the amount of bonds for sale was 2.5 to one the highest in years meaning that there was a lot of demand at that higher rate so it would seem that Spain is not in the same position as Greece.

Finally, after a day of riots the Greek parliament voted on the austerity package. The Prime Minister and the Finance minister gave impassioned speeches about the need for unity. The opposition laughed. There are 300 members of the Greek parliament of whom 160 were members of the ruling Socialist party. In the end 172 members voted for the measure and three of the Socialists turned in blank ballots and were promptly expelled from the party. In any case, the motion carried.

This vote was significant because the opposition, by voting against it can score points when the austerity begins to bite safe in the knowledge that no one will know what would have happened had they won, which is that instead of people taking 20% pay cuts the government would have stopped functioning altogether. This is great domestic politics but pretty terrible international finance. Because now if you are a potential Greek bondholder you know that almost half the government has no skin in the game with regard to actually carrying out the austerity program. Greece already has credibility issues this did not help.

THE REACTION

So how did the markets take the news. Well, at first the credit markets took it OK. They had really given the European governments a beating yesterday while the Greek riots were in full swing but once the Spanish got their bond auction off with a big bid to cover the credit markets tightened. The equity markets liked this even more and bounced into positive territory early in the morning before trading off on the fear that perhaps the Greeks would not pull off a win for the austerity program. When the Greeks approved the plan, equities had a brief bounce.

The FX markets however called bulls**t all day long. They slowly ground lower with each new news item. Keep in mind that the FX markets trade $3 trillion of value a day and people in the markets have been using dollar/euro as a proxy for the general perception of the success that policymakers are having with their efforts. The FX markets gave it a thumbs down and then the credit markets joined in. CDS markets for Spain and Portugal began to widen out. This is bad news for Portugal because they have to go to the markets to roll some debt that matures at the end of May. If they get that done they don’t have to do any more refunding until 2011 but you only need one auction to go wrong before its lights out.

THE EQUITY MARKETS

The equity markets soon enough began to sell off after watching the FX and the credit markets booing and hissing the powers that be in Europe. There was a selloff into the European close, then a little rally once the Americans were on their own. The view in the US thus far has been that this is a European problem, that Greece is small and we don’t really have to worry about it. European markets have wiped out all the gains from 2010 in the past few weeks on the back of the Greece problems and America has outperformed. Not today.

Today the markets began to think that perhaps all this credit trouble in Europe might tighten credit markets generally and smother the nascent American recovery in the crib. I think that American equity markets are probably the least well informed of the triumvirate as to what is going on in Europe but they could not ignore the Euro, the CDS for Spain and Portugal and the fact that the European equity markets have traded a lot lower than the US has. So they began to sell, and sell hard. Then something interesting and deeply disturbing happened.

THE DELUGE

A lot of people when they think of the stock market in the US think of those scenes from the movie Wall Street with a bunch of guys gathered around a specialist hollering buy and sell. That image is as close to today’s reality as tin cans and a string are to the internet.

In the US the equity market is made up of both the famous stock exchanges of which you have heard and several dozen ECNs or electronic crossing networks. The old line exchanges have market makers or specialists who are responsible for making a continuous two sided price all day long. These guys generally and specialists in particular long abused their advantageous market position to shave cash off of most market participants. Believe me. I know.

People got so fed up with the specialist system people came up with all kinds of alternative trading venues called ECNs. These ECNs had all kinds of rules, fee structures, or special features to entice market participants to trade on them and pay the owners a transaction fee. These venues have proliferated and have fragmented the market to some extent. The government tried to link them up with a rule called Reg NMS but has so far had mixed results.

Another interesting feature of modern stock markets is the role of high frequency traders. These are automated trading systems whose orders to buy and sell are generated electronically using a formula and which hold positions for extremely short periods of time. These types of firms have been slowly displacing the specialists and the market makers as the primary liquidity providers to the marketplace. The key difference between a market maker and a High Frequency Trader is that a market maker or specialist has an obligation to maintain a two sided quote subject to certain conditions while a HFT firm does not, they are pursuing an opportunistic strategy which contributes liquidity as a side effect.

As the markets came apart today it looks like some of the HFT guys contributing liquidity may have backed away from adding their liquidity to the system. Some trading algorithms which were written with certain liquidity assumptions sent market sell orders into the market and overwhelmed what bids there were. This had the effect of pushing the prices of some stocks on some ECNs to a penny a share. These orders should have been routed to an exchange where there was a bid but for some reason this didn’t happen.

Now most people don’t have the ability to watch all 14,000 listed stocks in the US so they watch indexes as a proxy the most notable ones are the Dow Jones, the S&P 500 and the NASDAQ. The indexes themselves are calculated by machines which take the prices of trades in the component stocks, add them up, divide by a divisor and publish the index. If you have a few stocks in which some trades are all of a sudden executed near zero, the index seems to have fallen quite a lot and that’s what happened this afternoon.

Once the zero prints went up in a few stocks artificially creating lower prices in indexes people could not tell just by looking at the indexes that there were erroneous trades being used in their calculation, they thought that there was a massive panic. And then they themselves panicked. Also computer programs designed to limit losses if indexes or shares decline to a certain point also kicked in and the markets completely fell out of bed.

It's actually hard to exaggerate just how much they fell out of bed. It was the largest point decline in the history of the market and the largest percentage decline since 1987 which was the all time record holder by miles. And the whole thing happened in less than 10 minutes and was over just as fast. Granted we recovered quickly and well but you can tell that there are a lot of very nervous people out there. It would seem there are also some very nervous computers out there as well.

There is a lot going on in the world, and you don't have to go far to find reasons to panic, but it was exacerbated massively by the fractured market structure of the US equity markets. Rest assured, Congress will address itself to this issue.

Oh Boy. And the casino opens again tomorrow at 9:30AM...

Now these Greeks were not afraid of a little austerity!

2010-05-05T17:53:00.000-07:00

Today the world was treated to a (and I know this phrase is much overused) Greek drama. As is well known the Greeks have been living beyond their means for quite some time and at last the German Ants have decided to rescue the Hellenic Grasshoppers from the fruits of their own fiscal profligacy. Whether this drama becomes a tragedy or farce for the bondholders will largely become clearer tomorrow when the Greeks vote on whether to accept the austerity measures that the EU and the IMF will demand of them as conditions for their aid. There is an EU summit tomorrow to discuss this and then the German Parliament has to vote on it Friday which should put it over the top.

In the interim the world has been treated to the spectacle of the Greek public sector unions raising a ruckus over the deep cuts in their salaries and pensions that the austerity package requires but which will still leave Greece with a 150% debt to GDP ratio by the end of 2013 so even with the $145 billion it’s still touch and go. It’s hard for me to understand what these guys are so mad about. The austerity measures the IMF and the EU are asking for are Draconian (another classical Greek reference) but they are nothing compared to what would happen in the event of an actual default. I think that these protests are more likely to do with general frustration rather than a specific policy which means they are likely to blow themselves out and the Greeks will get on with it.

That said I think there is something to be learned from all this. I tend to agree with most pundits that even if this particular episode is resolved sovereign credit issues are with us to stay both in Southern Europe and eventually throughout the developed world. At the end of the day the problem is this: Western societies are built on the assumption that the standard of living that developed here during the period of Western supremacy is a permanent state of affairs. For this to be true, the addition of several hundred million industrial and service workers to the global economy in India and Asia should have no effect on the standard of living. Naturally this is not in fact the case, the global market clearing price for a year of work in a factory is now well under $10,000 per year.

This is a disaster for the West, particularly the uneducated who are likely to take to the streets. Unable to cope with reality, our politicians have decided to try to use the relatively sophisticated financial infrastructure we have in the West to transfer the wealth of current bondholders and with them future taxpayers into the present to maintain the old living standards. This can be done for a little while, but not forever.

What Greece and its’ angry mobs are telling us is that the game is up.

It may be a storm in a teacup, but it can still kill you if you live in the teacup.

2010-05-02T16:45:00.000-07:00

So the Dubai World Drama continues. The powers that be at Dubai World are grudgingly considering raising to 2% from 1% the interest rate they’ll pay on the extended loans. Analysts say this would result in a 20-25% loss to the creditors. This is because while they would nominally get their principal back the amount of money they would earn in interest would be far less than they are expecting or could get elsewhere if they were paid back in full on time. Nakheel suppliers on the other hand are getting cash this month plus an Islamic security that will yield 10%. Reuters is reporting that the Bankers are not happy. Perhaps not unhappy enough to try their luck with a declaration of default but unhappy enough to push for more. The drama is not over.

Support for the deal is coming from an unsurprising source: Dubai itself. In a letter to the editor Nasser Al Saidi, the Chief Economist of the DIFC, has published a rousing defence of the Dubai World restructuring and has attempted to draw some lessons from it. While it is not surprising that Dubai is praising itself for its handling of the crisis two things are disturbing about the letter. The first is that the crisis is far from over: the Dubai World creditors have not accepted the plan, the losses elsewhere in Dubai continue to be staggering and Dubai has no room left to manoeuvre without another appeal to Abu Dhabi because they have completely drained the DFSF. The Second is the very disturbing sense I get from reading the letter that the powers that be in Dubai have neither a sure grasp of reality nor an awareness that, here in the future, their bold assertions of the impossible inspire laughter rather than awe.

Dr. Al Saidi says that the restructuring proposal “removes the cloud of uncertainty” which has hovered over regional markets of late and points to the recent declines of the Dubai CDS spreads from their crisis highs. Unmentioned goes the fact that Dubai CDS are still 150 bps higher than they were before the crisis began, are higher than either Portugal or even Lebanon both of which are in serious fiscal trouble. At 414 are right about where Greece was before its’ spike to 1000 and then forcible bailout by the IMF. It would seem that some uncertainty remains.

He goes on to say that the “main message emerging from the restructuring proposal is that the Government has treated both foreign and local creditors equitably and fairly, without discrimination, a clear refutation of some misinformation.” I find this hilarious. So, there are three main groups of creditors here: the banks at the Dubai World level (mostly international,) real estate investors at the Nakheel level (mostly Emiratis as they were given first pick of the land,) and trade creditors at the Nakheel level (also mostly Emiratis.)

So where does the money go? $8 billion goes to Nakheel, $1.5 billion to the parent, clearly favouring the Nakheel Creditors who are largely Emirati at the expense of the creditors of the parent company who are largely foreign. The banks (largely foreign) who extend their loans get 1%, the trade creditors (largely Emirati) who have to take some of their payment in newly issued bonds paying 10%. This is to say that the foreigners and the few Emirati banks involved lose 20-25% of the value and the trade creditors get paid a little something extra for their time. The good Dr. seems to think that just because they are not taking a principal haircut that the banks are not losing anything. On the contrary they are losing a great deal.

This is not to say that the Emirati trade creditors will not lose out as well. Even after another $8 billion is poured into Nakheel it is still a real estate development company in the worst performing and most overbuilt real estate market in the world. I would bet that despite the fact that their tradable securities will carry a 10% coupon that the Nakheel certificates will trade at a substantial discount in order to reflect this.

Dubai through the voice of Dr. Saidi goes on to congratulate itself for resolving the issues of ownership and taking on itself the burden of the equitization rather than compelling the creditors to do so. This is also a bit disingenuous because Dubai had no choice but to do so or else face a general insolvency and an involuntary equitization of both itself and the creditors. This plan as it stands drains the DFSF to zero and still clips the Dubai World creditors for 20% of the value of their investment. Had Dubai insisted on taking maintaining its position in the capital structure there would still be an equiziation but they would have also lost control. The restructuring allows them to pass losses to the creditors at the parent company level, drain the DFSF to try to revive Nakheel and pay off Emirati real estate investors and trade creditors and maintain control. Personally I think this is unwise because I do not believe Nakheel can be revived but this was not a selfless act by Dubai by any means.

He goes on to describe the restructuring as a triumph of federalism. This is also difficult for me to understand because the restructuring is entirely a Dubai only affair. Dubai drains the DFSF, which admittedly was originally from Abu Dhabi and converts its debt to equity. No new Abu Dhabi or UAE funds are involved. Indeed, the rescue of the trade creditors has enabled Dubai to maintain the independence of Arabtec. Now that the trade creditors are getting paid off in front of the creditors at the parent company level Arabtec does not need the Abu Dhabi lifeline and so has broken off its merger talks. It looks to me like this is the opposite of federalism, it is the reassertion of Dubai’s autonomy from Abu Dhabi though I think it is likely to be temporary.

After this Dr. Saidi draws a few conclusions:

1.) The middle east needs a better insolvency regime.
2.) Countries in the middle east should work to enhance the quality of their local currency debt markets
3.) Dubai should not borrow short term for long term projects.
4.) There should be more open communication by Dubai about the health of its state owned enterprises.

I think these are all reasonable suggestions though personally I think that the best way to achieve the first would be to actually put Nakheel into insolvency. Given that the local currency is pegged to the dollar by the vastly stronger power of Abu Dhabi I’m not sure I understand why there is a need to enable Dubai to borrow in AED. While its true that one should not borrow short term for a long term project that’s not really what happened here, they borrowed mid-term and then lit the money on fire with profligacy and corruption so that after several years of marketing and office redecorating there isn’t much left for the creditors.

The real problem with the essay I think is the last two paragraphs which I reproduce here:

Looking back at the last four months, the reaction caused by Dubai World’s debt restructuring announcement is best described as a “storm in a tea cup.” The facts are that the UAE, the GCC and the MENA region countries with access to international capital markets have never defaulted on their debts and obligations and have much stronger economic fundamentals than those of so‐called ‘advanced countries’ which were addressing criticism and ‘advice’.

So why the doubts and invidious questioning? One concludes that much of the media hype is politically motivated. Dubai’s Arab economic success story as a multi‐cultural, multi‐ethnic and multi‐religious hub and melting pot is clearly not to the liking of some countries with different geostrategic ambitions and outlooks and of some of the countries that were actively promoting the interests of their own companies against those of Dubai and DW.

The Dubai financial crisis has been many things over the past six months. One thing it has not been is a storm in a teacup. It was in fact a near death experience for Dubai’s sovereignty and it’s not even over because the success or failure of the restructuring, if it is even approved, turns on the successful resurrection of Nakheel. Furthermore Dubai is not stronger financially than either its advanced or its emerging critics. Dubai should not group itself fiscally with the rest of the GCC. Dubai CDS are trading today at 414 bps. Abu Dhabi is trading at 102 and Saudi Arabia is trading at 70. The markets see that Dubai is not in the same boat as the others, Dubai would be vastly better prepared to cope with what’s coming if it could come to terms with those facts as well.

Then there is the bizarre idea that this is all politically motivated by some unnamed countries which want Dubai’s multi-cultural multi-ethnic model to fail. This is preposterous. Dubai has engaged in massively self destructive economic policies. Those policies have destroyed tens of billions of dollars of value for both Emirati and international investors. If the foreign press was motivated by anything it was schadenfreude. The fact of the matter is that Dubai is simply no longer important enough for someone to go to the effort of manufacturing a crisis in order to bring it low. Indeed, Dubai’s most active enemy is itself. By perpetuating the fiction that its travails are the result of fear-mongering by invisible enemies it only lengthens the time it will take for it to take the bitter medicine and move itself forward.

Dubai to Creditors in "interest rate stand off:" DODGE THIS!

2010-04-18T17:53:00.000-07:00

So I have to admit that I am a little disappointed. I expected there to be a lot more suspense with regard to the Dubai World restructuring talks. Sure, there is a dispute regarding the interest rate that Dubai World will pay on the extended maturity loans that the banks will get. It seems that Dubai wanted to pay 1% fixed, a better rate than the US government gets for a similar term and the banks want them to pay 3% over LIBOR something more in line with what the actual risk of default is. To be fair this has the makings of some interesting drama. 1% flat vs. 3% over LIBOR is a pretty wide Gulf. At stake for the banks is a pretty big write down. You have to remember that when the banks put these loans on their books they include the future interest they are going to receive and therefore if they are going to get less interest that have to book a loss. At the Dubai rates the losses are over between 5% and 25% of the face value of the loans depending on the costs of funds of the banks. The FT describes the negotiations over rates as a “stand-off.”

So what exactly is the “stand-off?” The FT article goes on to say that the banks are not concerned about principal repayment and are not negotiating the fundamentals. Personally I think those issues merit far more attention. The fact is that in this transaction Dubai has completely drained the DFSF, the restructuring is completely a Dubai only affair. $1.5 billion of the remaining funds go to pay interest on the Dubai World debt the other $8 billion goes to Nakheel where the Sukuk holders are to be PAID OFF IN FULL. That’s right, the creditors of the subsidiary are getting 100% of their money back while the creditors of the parent are taking a 5%-25% hit to their P&Ls.

This is a huge victory for Dubai. The Dubai World creditors are going to sit back and watch while $8 billion is pumped into Nakheel to rescue the Emirati trade creditors and real estate investors. Thier principal repayments will threfore hinge on whether Nakheel can be brought back from the dead. The seem blisslfully unaware of the fact that Dubai real estate is off 30%, and the last thing Dubai needs is for Nakheel to come back to life and create even more supply. If I were a member of the creditor committee there would be a “stand-off” all right but it would sure as hell involve the fundamentals. There is no way I would allow the Sukuk holders who in event of default get worthless desert to be paid off in full when in event of default I get Dubai Ports World and whatever assets in Istithmar are above water as well as the JAFZA. Yep, that would be my stand off.

When someone says the word “stand-off” to me I generally think of Clint Eastwood on the main street of some town in the American West facing off against some other gunfighter or the final scene in a Quentin Tarantino film where everyone is pointing a gun at everyone else and there’s some real tension. In this case I don’t think it’s like that. I think it’s more like the joke where an aging Winston Churchill asks a young socialite whether she’ll sleep with him for five million pounds. The socialite, after some reluctance flirtatiously agrees. Then Churchill asks her whether she’ll sleep with him for five pounds. At this the socialite declares “Mr. Churchill, what kind of woman do you think I am?” To which Mr. Churchill responds: “Madam, we’ve established that, now there is simply a matter of price.”

OK Creditors, this is Nakheel and once we bring him back from the dead he'll pay you off in full. Nurse,Set the charger to $8 billion: CLEAR!

2010-04-05T19:33:00.000-07:00

My apologies, friend readers, for my extended absence. I have been engaged in an alien activity called “working.” But that’s all done with now and I can turn my attention back to the goings on in Dubai.

So it seems that the equity and credit markets have decided that the Dubai World proposal was “better than expected” and have roared their approval by taking prices higher, particularly of the Nakheel Sukuk. The prime causes for celebration are the fact that Dubai World beat its own deadline, making its announcement on the 25th, and the simple fact that there was an announcement and a more or less detailed outline plus a conference call was vastly more transparency than has come out of Dubai regarding this since the whole crisis began back in November. So gratifying was the transparency that the Citibank report on the subject was entitled “Dubai Restoring Confidence Sooner than Expected.” For people voting with their dollars in the credit and equity markets this seems to be the case. The question I have to ask is, is that confidence justified?

The terms of the deal are interesting in themselves. As I mentioned in my earlier note, this is a Dubai only show. Dubai basically converts all the money that it has previously lent to both Dubai World and Nakheel into equity, putting the other creditors ahead of itself. A noble gesture, this. It then drains the DFSF, putting $8 billion into Nakheel and $1.5 billion into Dubai World. The Dubai World creditors will be invited to roll their loans out into new ones with maturities of 5 and eight years. The repayment of the principal of these loans will be from operating earnings and asset sales.

The Nakheel proposal is the more complex and more interesting one because it has a lot more moving parts. So $8 billion goes in and immediately $1.5 billion goes to continue work on existing developments with the hope that this will unlock additional payments from off plan buyers and that buyers of developments which are “long term” (ie they will never be built) will be willing to swap their claims into projects that may actually exist. Trade creditors under 500k AED are paid off in full and those over 500k AED will get 40% cash and 60% in a tradable security. Sukuk holders will be paid off on time and in full. Bank creditors will be asked to roll their debts but with market interest rates. DFSF will equitize its loans.

Despite the intricate plan and the cash behind it there remain a few questions. Dubai has been obtuse in discussions of whether any further support will be forthcoming or whether any guarantees are being extended. Many details about the tradable security are left to the imaginations of the creditors and the bankers. Also no mention is made of what interest rate, if any, the extended Dubai World debts will pay. And of course on top of these questions rests the $23 billion question of whether the creditors will accept this deal.

The question I would be asking if I were a Dubai World creditor would not be about the interest rate or about the tradable security. I would be asking why they were going about it this way? It would seem to me that if the tools in the tool box that Dubai could deploy were debt forgiveness through equiziation and a willingness to completely drain the DFSF then this seems a pretty odd way to deploy the capital. I’d think they would be better off putting Nakheel into liquidation in order to rescue the creditors at the parent company level would have been optimal. They could have simply defaulted on the Nakheel sukuks and then handed the worthless collateral over to the bondholders. They could have put whatever projects have been completed but not pledged and the remainder of the land bank up for auction and then paid out the proceeds to the trade creditors and the bank lenders and if anything was left over for them they could have passed it up to the parent. If they had done this then they would have been able to devote an additional $8 billion to Dubai World or rather would have had to conduct $8 billion fewer asset liquidations.

Instead what the restructuring plan represents is a “Hail Mary” pass to try to resuscitate Nakheel. The theory seems to be that if they pump the lions’ share of the remaining DFSF funds into Nakheel they can get some of the Dubai Waterfront projects off the ground. The idea must be that then it can be made into a going concern that will enable them to pay off the sukuks, the Nakheel Bank creditors and pass funds up to the parent and pay off the holders of the new five and eight year bonds with the mystery interest rate. There’s probably more to it than that. Dubai has become an Islamic financial center for it to become the site of the largest Islamic default in history is probably not a good idea. Also there seems to be a disproportionate amount of attention being paid to the well being of the people who own off plan real estate in Waterfront, what are the chances that these are largely Emiratis? Pretty good I would say. How about the trade creditors? Probably the same, it’s probably also the case that Arabtec’s new owners, the same guys who filled up the DFSF in the first place, are probably also big fans of the consideration being shown to the Nakheel trade creditors.

From this perspective I wonder how the creditors of Dubai World at the parent company level feel. Under different discount and interest scenarios Merrill Lynch estimates that the Dubai World creditors will take a $0.32-$0.55 cent on the dollar loss under this restructuring. If you were such a creditor how would you feel about Dubai pouring $8 billion into Nakheel, an entity which has an absolutely atrocious operating history, has been involved in all manner of shady dealings most of which will never come to light and which has already swallowed billions and billions of dollars. Fine, they’ve replaced the chairman of Nakheel though he remains the Chairman of Dubai World but they’ve replaced him with another Emirati whose chief qualification is almost certainly his willingness to toe the party line as well.

Then you have to ask yourself what is the business proposition into which this $8 billion is being poured? The idea behind it is that a profitable return can be generated on another new massive real estate project in Dubai. I find this almost impossible to believe, it’s as if the people in charge of this thing have not read a Dubai newspaper in the past 18 months. Dubai real estate has fallen off a cliff. Most property holders in Dubai are just trying to stay out of jail for not bouncing checks and now the DFSF is interested in pouring $8 billion into Nakheel in order to add another Hong Kong to an already collapsing real estate market? And if you are a Nakheel 2011 sukuk holder or a Dubai World holding company creditor like it or not this is the bet you have on, because if it doesn’t work you don’t get paid. If you had a choice would you take that $8 billion and invest it in Dubai real estate or would you just pay yourself with it and call it a day?

I guess we’re going to find out what the creditors think. There may be more transparency but it’s just revealing a different drama.

It's hard to keep up with it all.

2010-03-25T03:58:00.000-07:00

So the word is out about the Dubai World plan. The markets seem to love it.

So I have read the press releases and someone was nice enough to send me a transcript of the conference call. Naturally I'll have to write more extensively a bit later but my initial thoughts are the following:

1.) As I would have imagined much more support is being given to Nakheel than to Dubai World both because it needs more and also because it's creditors are more likely to be hostile.

2.) The support of Abu Dhabi in this is conspicuous for its absence. Dubai is basically draining to zero the DFSF and throwing in additional money from the Emirate of Dubai and converting what debt is owed to Dubai to equity putting itself behind other creditors. It is a Dubai only show.

3.) Despite the cash injection Nakheel is explicitly not granted any government guarantees. During the conference call the spokesperson declined to comment on any government guarantees of Dubai World itself on account of a "confidentiality agreement." I'm not sure what that means. How can a government guarantee instill confidence if it is protected by a non-disclosure clause. Seems kind of self defeating.

4.) The Nakheel restructuring plan is quite complex. $9.5 billion goes in from Dubai and the DFSF to "fund operations and liabilities." Fund operations? It seems that they are very concerned about a group of creditors which I have not so far considered on this blog: the people who bought real estate off plan and whose projects have stalled. It seems they are going to put the funds toward continuing construction and will offer swaps to off plan installement buyers in the developments which can be completed. They are also going to pay off trade creditors for under $500,000 in full and creditors over that amount will get 40% in cash and 60% in a "tradable security" so that they recieve 100% of their credit back. Anyone want to bet with me that the "tradable security" will trade at a substantial discount to face almost immiediately?

5.) I'm not sure what all this means for the Nakheel Sukuk holders. They seem to me to continue to bear a substantial amount of risk to Nakheel, Nakheel's execution capaility and through that to Dubai real estate in general. As I mentioned in my last post about this the trouble for Nakheel is that it can't raise new capital to continue its operations. So what Dubai is doing is going all in, not to secure the sukuk holders, but to continue operations. To do so it is using the money to continue construction, but is only paying out existing trade creditors 40% plus some "tradable securities."

Looking at the balance sheet of Nakheel as of June 30 2009, it seems that the accounts payable represent 28 billion AED, 40% of which is 11.2 billion AED or $3 billion. So now there is $6 billion left to fund operations and pay liabilities. Presumably the reason they want to continue operations is so that they can actually recieve some of the 17 billion AED they are owed in off plan installments but I wonder how much of the remaining $6 billion will be required to do that. The press release says a "substantial" amount will go toward construction.

If I were a sukuk holder I would sell on this pop.

6.) Interestingly I'm not sure the sukuk holders will get a chance to vote on the proposal because in the view of Dubai World they are unaffected assuming all other stakeholders agree to their restructuings. There are no changes to the terms of the sukuks being made. This is almost certainly because the sukuk holders are likely to be the mst recalcitraint group.

7.) The Nakheel proposal is very complex and requires a lot of people to agree to things which seem a little far fetched. Trade creditors have to take an opaque haircut determined by the degree to which their "tradable securities" trade at a discount. The bank creditors all need to agree to extend maturities. Owners of non-existent apartments on non-existent islands have to agree to take villas that are actually being constructed in a different location. There are a lot of moving parts and I think this announcement is a major step forward. However, I don't think this story is over.

Wow, the news flow out of Dubai is pretty fast and furious

2010-03-24T03:55:00.000-07:00

OK, I just got out of bed in New York and now it's on the tape that Dr. O has been arrested. Interestingly I have already written on this subject a while back. More than once actually. Maybe I should have a new tag line for the blog: "Wall St. WTF, todays news three months ago." Kidding, this is more about ex post facto analysis. Breaking the news is for those guys and gals at The FT, The National and Zawya. Stay tuned.

The DFSA Shows us its' War Face, it needs work but it's a start.

2010-03-23T01:47:00.000-07:00

I have to be totally honest. When I first saw the news on Bloomberg that the DFSA had dissolved the board of Damas and taken action against the brothers Abdullah I engaged in not a small amount of triumphalism. After all I had been railing against these guys and the inaction of the regulatory authorities in my blog for months. Whenever I logged into Bloomberg right after checking the markets I would look up Damas news to see if there was anything I could write about.

When the news finally went across the tape, I felt vindicated. I felt as though my blog had played a role in bringing it about. By constantly harping on it and claiming that it would undermine the confidence of the markets in the DIFC and thereby damage the Dubai World restructuring I felt that perhaps I helped force the powers that be in Dubai to act. Having read the report of the DFSA I was especially vindicated in my decision to publish the tip I received on the true purpose of the Dubai Ventures vehicle. Of course the DFSA report contains many things on which I did not report so perhaps I didn’t have too much to do with it. I’ll console myself with the thought that somehow the 50,000 page views that my Damas articles have gotten over the past few months had at least some influence on the decision of the DFSA to act if not a decisive one.

The DFSA report itself reads like a spy novel with a surprise ending. It opens with a cast of characters and a list of weapons. First the villainous Brothers Abdullah and their tools of espionage and deception: the various legal entities, assets, and liabilities front companies and the like. Then there is our hero the DFSA with its’ virtuous arsenal outlined in the section entitled “Relevant Legislation and Rules.” When you get into the main body of the it has exciting chapters like “The 42.5 Million Transaction” or “The Gold Transaction” or, exotically unless you have been there, “The Sharjah Transaction.” Step by step, transaction by transaction you can see our hero stalking his prey. Layer by layer a truly astounding series of frauds are uncovered.

The brothers Abdullah siphon millions of dollars out of the company into their private accounts. When money is tight they conspire with Dubai Ventures to rig an IPO on the DIFX in order to swindle $170 million out of international investors which they promptly use a variety of means to steal. They use company funds to buy a building in their own name and then sell the building back to the company for a huge multiple of the original price and pocket the difference. Over two tons of gold go missing into the pockets of the Abdullah brothers never to be heard from again but are magically replaced from the company’s own stocks. Money is borrowed in the name of the company and paid out to the brothers. Land owned by the brothers is sold to the company for 46 million AED without any independent valuation. To the Brothers Abdullah Damas is a treasure house to be systematically looted, to the shareholders it is a house of mirrors: a mystery, wrapped in a riddle locked in an enigma.

But the DFSA is on the case. With every paragraph we can see our hero get closer and closer to the quarry. Stalking him, laying the trap, ready to spring... It’s like watching James Bond tailing a Evil Mastermind, through the labyrinthine streets of some ancient city. The Mastermind is so confident that he is above the law that he doesn’t even notice the agent stalking him. He brazenly goes about hatching and executing his evil plans little knowing that the Bond/TheDFSA are hot on is tail, watching, building the case, planning, waiting for the moment to strike.... Then, the moment comes. The Mastermind turns his back and Bond/DFSA springs into action, reaching into is coat pulling out his weapon and plunging it into the back of the villain... WHO BURSTS OUT LAUGHING BECAUSE OUR HERO HAS JUST SPENT MONTHS STALKING HIM IN ORDER TO STAB HIM WITH A SAFETY PIN.

I don’t want to admit it but that’s how the thing reads on the first pass. If you read the entire document the punishment does not seem at all to fit the crime. These guys stole 600 million AED or almost $170 million, the entire proceeds of the IPO not counting the fraudulent investment in the IPO from Dubai Holding. I’m sorry did I say steal? The DFSA calls them loans with non-commercial terms such as "without interest and with no fixed repayment date or schedule." Hmmmm... what is the difference between a gift with an option to repay and a loan with no obligation to repay? Or for that matter between having someone steal from you or borrow from you without asking or paying interest for an indefinite period? If you’re a shareholder, nothing.

The Abdullah Brothers borrowed/stole it using every kind of scheme and ruse imaginable and what does the DFSA do? It fines them $3million, $2.7 million of which is suspended indefinitely. So the bill due to them: $300,000. To put that in perspective if the Brothers Abdullah invested their ill gotten gains in 2 year T-Notes they would have earned their fine twice over in the time it took the DFSA to investigate their frauds, no problem DFSA. Heck, if you wait 18 months we can pay the whole $3 million back just with interest we earn on what we borrowed/stole. That is an awesome deal for the Brothers. So what do the shareholders get out of all this? The same deal the Brothers Abduallah negotiated with themselves and the Board which was recently fired. They promise to pay back all the money over time and if they don’t they agree to hand over their shares which are now worth vastly less than $170 million. Actually, try less than half that. Not such a great deal, it sounds like the Abduallah Brothers come out on top.

That’s one way to read it and that’s how it appears on the surface but, as with so many things in Dubai, you have to look a little bit past that to get the whole story. One of the things that the DFSA order does is compel the Brothers Abdullah to provide a list of all their assets both those they own free and clear and those which are encumbered in some way. It then places a lien on behalf of Damas on all these assets. Their original agreement with Damas gave them quite a bit of leeway as to whether and how they disposed of what assets they have with regard to repayment of the funds they withdrew from the company for their personal use. Now virtually all their assets are pledged to the undertaking, not simply their shares in Damas. Also the undertaking empowers the DFSA to seek additional legal action for the enforcement of this pledge in DIFC courts, decisions of which can then be handed to Dubai courts for enforcement.

On the surface this seems like a pretty weak judgement, and according to the letter compared with what one would expect in the United States it is a pretty weak judgement but it is important to remember the context. What this undertaking essentially does is economically destroy one of the most prominent business families in Dubai. It is important to remember what the financial position of the Abduallah Brothers most likely is. I joked earlier that if they invested their ill gotten gains in T-Notes they would earn back their fine every ten weeks or so. The truth is they did not invest in T-Notes, they invested in Dubai and other real estate projects right through the peak of the market. I would say it is a near certainty that they cannot afford to repay Damas, which they are obligated to do on a timeline and for which all their assets have now been pledged. Whether they are fined $300,000 or $30 million makes no real difference, they are going under because of the repayment clause. This is not over, the undertaking is the beginning not the end of the travails of the Abdullah Brothers. When they miss the first instalment of their payments to Damas we will see what the DFSA does to enforce this agreement, then we’ll know whether it has teeth or not.

I think there is another aspect of this that might not be obvious to a Western observer. The school of Sharia law practiced by the courts in the GCC does not necessarily have the concept of precedent. It is up to the judge to interpret the Koran and the Hadith according to the dictates of his own heart as he sees them in the circumstances presented to him. This makes it extremely difficult to obtain legal certainty and therefore Arab businesspeople will go to almost any length to stay out of court. In such a world, in order to have orderly commercial relations with other Arabs it is therefore essential to maintain a reputation for probity.

Such a reputation has real commercial value because if you have a reputation of dishonesty people won’t deal with you because they know they cannot enforce contracts against you. The Abdullah brothers were among the most prominent families in Dubai and the public exposure of their malfeasance, even if it was suspected before, will do real commercial damage to them. Even Mohammed Alabbar, probably the most prominent businessman in Dubai is caught up in the whole thing and has been forced from the Board.

Importantly, this undertaking fundamentally destroys the asset that was most important to the Abdullah brothers and the only thing that would enable them to recover: their good name. This sort of thing almost never happens in the middle east because the preservation of face is so important and many people consider it unIslamic to attack the reputation of another person. The fact that the powers that be in Dubai have allowed one of their most prominent members to be so publicly humiliated is, though perhaps small to Western eyes, a real step forward for the region.

STOP THE PRESS! DFSA TAKES ACTION AGAINST THE BROTHERS ABDULLAH

2010-03-21T09:40:00.000-07:00

As longtime readers of this blog will know I have written extensively on the subject of The Great Damas Heist. I wrote not one but two articles on the damage this did to the DIFC generally. I wrote a few articles on the Heist itself and what I thought was a strange arrangement whereby the brothers basically agreed with themselves how they would go about repaying the money and suffered no regulatory sanction at all. I wrote about how the DFSA needed to be all over these guys and encourage my readers to take action.

Today they did take two actions. The First is an agreement with the Abduallah Brothers and the second is an agreement with the board of Damas itself. I have to go through the documents before I write a longer post but, having taken all involved to task so aggressively, I wanted to give credit where credit was due. It had bothered me deeply that a long night of financial opacity was descending on the DIFC, a place I had worked so long. Now that night has been broken by at least a single star of hope.